What happens at the end of a novated lease?

A novated lease allows you to pay for a car with your pre-tax dollars. However, you don’t automatically own the car at the end of the lease. Instead, you’ll have several options to consider.

One option is to swap your current vehicle for a new one with a fresh lease, much like upgrading your smartphone every few years. Alternatively, if you’ve grown attached to your car, you might want to pay off the residual value of the car, allowing you to take full ownership. Weighing these options carefully can help you make an informed decision.

If you are looking to finance a new set of wheels, you could either take out a loan or enter into a salary sacrifice arrangement with your employer to pay for the car with your pre-tax dollars.

You can picture a novated lease as a three-way arrangement between you, your employer, and the lender. It allows you to use your pre-tax income as a salary sacrifice, with the potential benefit of reducing your taxable income.

A novated lease typically lasts for two to five years. During this period, your employer directly pays the leasing company for the car, with the payment deducted from your pre-tax salary.

At the end of the novated lease period, you’ll likely have a residual amount to settle. At this point, you can choose to pay the residual value to own the car outright, or explore the option of upgrading to a different vehicle. Here are a few choices that may be available to you when the lease ends:

• You could pay the residual amount and own the vehicle outright.
• You could extend the lease on the car or refinance the balance to continue using the vehicle while avoiding a lump sum payment. However, you may end up paying more in interest charges over time.
• Return the car to the leasing company and take out a new lease on another vehicle.

The residual value in a novated lease is the final payment representing the value of the vehicle at the end of the lease. As the vehicle is novated to you during the lease period, you don't create any equity in it.

The monthly payments that you make only partially cover the vehicle’s cost so that you are left with a residual amount at the end of the term, which is equal to the market value of the vehicle after depreciation. Depending on the terms of your agreement, you can choose to pay this residual amount to the lease provider and own the car.

The Australian Tax Office (ATO) provides a scale of Residual Value 'minimums' that reflect the likely market value of a vehicle at the end of the lease term. The residual value is generally a percentage of the cost of the car, and the longer the lease term, the lesser will be the car's residual value. For instance, when you lease a car for a period of 12 months, the likely residual value of the car at the end of the term will be 65.63%of its cost as per the ATO. This figure reduces to 28.13% for a 5-year lease term.

At the end of a novated lease, you typically have three options: paying the residual value to own the car, refinancing the residual value to continue using the car, and trading in the car to upgrade to a new vehicle by entering into a fresh lease arrangement.

Paying the residual value to own the car

You likely know the residual value for your lease at the beginning of the term, as this figure must be specified in the lease agreement for it to be legitimate. You can use a savings calculator to figure out how much of your pay you need to set aside each month to make the lump sum payment to own your car at the end of the lease term.

Once you have paid off the vehicle's residual value, it's yours to own and enjoy for as long as you like. You'll also see your take-home income rise, as you would no longer be making any car payments from your pre-tax income.

Refinancing the residual value to continue using the car

Depending on the car's value and the lease's duration, the residual value at the end of the term could be a significant amount that you cannot afford to pay in one go. If you find yourself unable to afford the lump sum payment at the end of the term, you may want to renegotiate the lease to cover this amount.

Exchanging the vehicle for an upgraded or different model

One of the advantages of a novated lease is the flexibility to upgrade to a new vehicle at the end of the lease. If you think the car is no longer suited to your needs, you can choose to trade it in for a newer one.

In this case, the balloon payment or the residual value will become part of the new lease agreement. Another alternative is selling the car to cover the residual value and then entering into a fresh arrangement for a different vehicle. However, you run the risk of paying the difference between the car’s residual value and market value from your pocket if it sells for less than what you had anticipated.

If you are switching jobs, it's generally possible to transfer your novated lease to your new employer, provided they are willing to administer it. If that's not possible, you could speak to your financier to have your novated lease refinanced into a personal loan or a secured car loan.

However, this option will see you losing the tax benefit associated with a novated lease, as you'll be making the loan payments from your take-home salary. It's also worth checking for any termination fee if you are ending a novated lease early.

Novated lease vs car loan: What should I choose?

When choosing between a novated lease and a car loan, it's essential to weigh the novated car lease pros and cons. Both options allow you to finance a car for personal use, with regular payments and the option for a lump sum balloon payment at the end of the term.

Compared to a regular car loan, the main benefit of a novated lease is reducing your taxable income. It's also possible to get your car's running costs bundled into the lease, making it easier to budget for various expenses, such as fuel, insurance, servicing, and tyres. On the flip side, you won't own the car at the end of the lease term, as you would with a car loan. You'll either have to pay the residual value to own the vehicle or return it to the leasing provider, depending on the terms of your agreement.

Consider how you’ll use the car in the future, and check with your employer to see if they’ll offer a novated lease on your vehicle, before deciding on the best option for you.