The differences between novated car leases and car loans

 How do novated car leases work?

A novated lease is a three-way agreement between an employee, employer, and a novated lease provider. You need to be an employee, receiving a wage and paying tax through the PAYG system, to consider this option. 

Once you have approval from your employer under a salary package arrangement, a novated lease allows you to make repayments from your pre-tax salary,  and that has the potential to reduce your taxable income and result in a tax saving. 

You also save money because the leasing company is generally liable to pay GST to the Australian Tax Office (ATO) on the lease rather than you. In the case of fringe benefits tax, it's the employer who is generally liable, but it must be a bona fide lease, as outlined in the ATO guidelines.

Do novated car leases apply to EVs?

Novated leasing an electric vehicle can potentially save thousands in Fringe Benefits Tax. In 2022, the Federal Government introduced an Electric Car Discount Policy, providing a fringe benefits tax exemption for EVs financed under a novated lease, as long as the cost of the car is below the luxury car tax threshold ($89,332 in FY2023-24).

This means you can salary package the finance plus running costs out of your pre-tax salary.  It applies to all new EVs bought after 1 July 2022 and secondhand EVs first registered after 1 July 2022, and includes plug-in hybrid EVs if the lease starts before 1 April 2025.

Whether you lease or purchase a used EV, there are some important factors to consider, such as the health and lifespan of the battery.

What happens at the end of a novated lease term?

The lease term is usually between one to five years and there is a residual value, known as a balloon payment or lump-sum payment, that is due before you can own the vehicle. 

Your end-of-lease options include upgrading the car, refinancing the car for the residual value or keeping the car. If you decide to own the car outright, then you will need to cover the running costs and you lose any benefits that you had through a salary package arrangement.

How do car loans work?

A car loan is a traditional financing option, where the borrower takes out a loan from a financial institution with the car they are buying used as security for the loan, although other assets may be taken into consideration.

The interest rate can vary and lenders typically base this on a variety of factors, such as your credit score, type of asset, and loan to value ratio.

There are generally upfront fees and a number of lenders also charge monthly fees. RACV has a wide range of car finance options, and there are no ongoing fees for new, used or green car loans.

Most car loans are fixed term loans, giving you the certainty of knowing your repayments, but early termination fees are a consideration. Some lenders may offer a variable rate loan, but this is more typical for home loans.

As a borrower, you make regular repayments to the lender, typically with interest, until the loan is fully repaid.

What happens at the end of a car loan term?

The loan term is generally between one to seven years, allowing you to choose a loan term and repayment structure that best suits your financial situation. Car loan balloon payments tend to vary depending on the loan provider, so it is important to do your due diligence on the lender you choose.

RACV Finance car loans do not currently require balloon payments at the end of your car loan. Differing from novated leases, car loans allow you to own the car outright once the loan is repaid. This provides the flexibility to sell the car as desired. 

Pros and cons of having a novated lease

Pros

A novated lease allows you to combine the total cost of running your car - the running costs and finance costs - into one payment from your pre-tax salary. This makes it easier to budget and cover costs such as fuel, maintenance, insurance and registration. 

You can chose a lease term that suits your budget, from one to five years. You can lease a new car, used car or even a car you already own, with the potential for tax savings.

Novated leases often come with the option to upgrade your car at the end of the lease term, giving you the flexibility to switch to a newer model.

Cons

If you wish to lease a used car, you may be limited in your choice, as the vehicle can't be more than 15 years old.

If your employment status changes or you change jobs, the responsibility for the lease will shift to you. You can continue making the repayments yourself until you find a new employer who is willing to re-novate the lease, or sell the vehicle and pay out the outstanding finance amount.

Pros and cons of having a car loan

Pros

One major advantage of a car loan is that you own the vehicle from the start, albeit with a debt that needs to be paid off. Car loans also typically provide a fixed interest rate, allowing for predictable monthly payments over the loan term, and you have the option not to have a residual at the end of the car loan.

Additionally, car loans offer flexibility in terms of choosing the car you want, including luxury EVs and classic cars.

Cons

If you're paying off a car loan, this debt will count as a liability. You will also need to budget and pay for car maintenance, insurance, and registration out of your post-tax salary.

Car loans may require a larger upfront payment compared to novated leases.

If you fail to make repayments, the lender can repossess the vehicle to cover their losses. If you decide to sell a financed car before you've paid off the loan, you'll need to talk to the lender first. Not only will the sale price of the car need to cover the outstanding balance on your car loan, you may face early exit fees.

Financial considerations

One of the primary factors to consider when comparing novated car leases and car loans is the possible difference in interest rates. With novated leases, the company facilitating the lease may only work with a limited panel of lenders, meaning you may not have access to the lowest rates. Whereas with a car loan, you have more flexibility to shop around for a rate that suits you.

Another important consideration is the tax implications of each option. Novated leases can provide potential tax benefits, because lease payments are deducted from your pre-tax salary. This can help reduce your taxable income and ultimately lower your overall tax liability.

On the other hand, car loans do not offer the same tax advantages, as the repayments are made out of your post-tax salary.

In addition to interest rates and tax implications, it's crucial to take into account the fees associated with each option. Novated leases typically come with ongoing administration fees. Car loans, often involve application fees and potentially early termination fees, if you choose to end your loan term early.

Practical considerations

A key consideration is the car running costs. With a novated lease, you can combine the running costs and finance costs into one payment from your pre-tax salary. You may prefer the convenience and predictability of this option when it comes to budgeting for your car's expenses. With a car loan, you'll need to account for these costs separately.

With a car loan, you can also trade in your old car, and the trade-in value will go towards reducing the overall loan amount.

Lastly, it's important to consider residual/balloon payments. A car loan typically does not involve a residual payment. Instead, you'll be responsible for repaying the full loan amount over the agreed term.

In contrast, a novated lease will have a balloon payment that is due before you can own the vehicle. There are also tax implications if you decide to buy the vehicle outright rather than upgrade to a new car and continue the lease.

How to decide between a novated lease and a car loan

If you're an employee and can consider a novated lease, then your financial situation plays a crucial role in determining the most suitable option for you. With a novated lease, your employer deducts lease payments from your pre-tax salary, potentially reducing your taxable income. This can be advantageous if you're looking to maximise your take-home pay and enjoy potential tax benefits.

The benefit of a car loan is that you are able to purchase the car without having to pay anything upfront. You're also working towards owning the car outright within one to seven years, depending on the terms of your loan.

Next, consider your car usage. Novated leases are often favoured by individuals who use their cars for work-related purposes, although this is not a prerequisite to having a novated lease. If you're regularly driving for business or have a long commute, a novated lease may be more appealing as it covers not only the finance but also other vehicle-related expenses such as fuel, car insurance, and maintenance.

However, if you primarily use your car for personal reasons and have a predictable annual mileage, a car loan might be a better fit.

Finally, think about your long-term plans. Novated leases typically have a fixed term, usually between one to five years. If you prefer to upgrade your car frequently and enjoy the latest models, a novated lease offers more flexibility. Conversely, if you prefer to keep your car for a longer period, a car loan provides you with the freedom to make that choice.