Pay me now or pay me later

solarMy nephew is looking to lease a solar system for his house. He’s narrowed it down to two options that offer equivalent systems. The question is the pricing structure. One has a low starting monthly payment, which increases each year, and the other has a fixed monthly payment. Which to choose?

Here’s a spreadsheet that compares the annual cost of each, year-by-year: pay me now. Option 1, with the lower initial cost, is less expensive for the first 7 years, but after that Option 2 costs less. Clearly, Option 1 is the choice if he stays in the house less than seven years.

pay me now annual

But he plans to live there more than seven years. Will he save enough on Option 2 in the later years to make it worthwhile to give up the early year savings offered by Option 1?

The simplest way to look at this is to calculate the cumulative costs for each year. Option 1 is less up through 2027, but if he stays in the house beyond that, Option 2 costs less. A more realistic way to look at this is called present value, and it’s based on the fact that money now is worth more than money later. For example, with inflation at 3%, a dollar next year is worth only about 97 cents this year (calculated as 1/(1+.03)). We figure the present value of a dollar each year in the future and see that by 2028 a dollar will buy only two-thirds of what it does now, assuming the 3% inflation rate continues. We use those numbers to get the inflation-discounted cost each year, add it all up, and get the cumulative present cost of each option.

If he plans to keep the house and the solar system at least through 2028, he’s better off with Option 2.

pay me now pv

The choice of the interest rate matters. Businesses will generally use larger rates (called discount rates) to calculate present value to account for risk. If you use a 10% rate, it will be a few more years until Option 2 becomes the less expensive choice.

This isn’t the whole story, of course. Any analysis of a lease needs to include what happens when the house is sold. Is the solar system lease transferable to the new owner? If not, what are the costs to pay off the lease? Since these costs may be far in the future, it makes sense to use present value to consider them.

By the way, if you’re in Southern California on July 10, please join me in Torrance for a free workshop, Instant Insights with Microsoft Excel.

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