What Is a Capitalized Cost Reduction?
A capitalized cost reduction is any upfront payment that reduces the cost of financing. A capitalized cost reduction is generally associated with the purchase of a home or automobile. Reductions can be made from cash, the value of a trade-in vehicle, or through rebates.
- Capitalized cost reductions reduce the amount of principal a borrower needs in a financing agreement.
- Capitalized costs reductions are often the result of down payments, rebates, or trade-ins.
- Capitalized cost reductions are common in purchases of real estate and large, durable goods.
Understanding Capitalized Cost Reductions
A capitalized cost reduction is negotiated at the beginning of a financing deal. It generally is also known as the value of a down payment. A seller provides the buyer with an understanding of the total amount they must pay in the future, both with and without the down payment as a capitalized cost reduction. Generally, capitalized cost reductions are not allocated to a specific area but rather reduce the entire amount a buyer must pay, including fees and extraneous charges.
A seller or lender working on behalf of a buyer will usually request financing principal based on all of the costs a buyer must pay at closing time. A down payment serves as a capitalized cost reduction by lowering the total amount of principal financing a borrower needs. A down payment can greatly help to reduce the installment payment amount owed from a buyer on a monthly basis.
Capitalized cost reductions are common in a home purchase. In many cases a down payment is usually necessary for a mortgage loan, unless borrowing from a government-supported loan program. Most traditional lenders will require a down payment of approximately 10%. The down payment goes toward the principal amount a borrower needs to cover the transaction comprehensively. Essentially the down payment is subtracted from the total amount a buyer must pay. This leads to the total cost of financing a borrower must request.
Down payment levels typically have no limit. A mortgage borrower could potentially make a 50% down payment for a significant capitalized cost reduction. If a borrower makes a 50% down payment, the value they must borrow is just slightly more than 50% of a property’s purchasing price after factoring in any extraneous costs involved. This means that the payments a borrower must make over the life of the mortgage loan will be substantially lower due to the high initial capitalized cost reduction and the lower financing need overall.
Cars, Trucks, and Heavy Machinery
Capitalized cost reductions can be slightly more complex when analyzing capitalization costs for cars, trucks, and heavy machinery. This is because these large, durable goods can often be purchased or leased.
A capitalized cost reduction can be used in both leasing and purchasing. In a purchase or a lease the same basic methodology is used for calculating the financing principal. However, the amount of principal needed is usually lower in a lease because of the circumstances. Both leasing and buying scenarios are often offered to car, truck, and heavy machinery buyers, requiring some careful consideration.
Leasing is ultimately renting a vehicle for a long-term. It can sometimes be a more affordable option for borrowers on a tight budget. In a lease contract, the capitalized principal is based on the value of a vehicle’s depreciation over the term of the lease contract. In a three-year lease contract, a borrower would only pay the value of a vehicle’s depreciation over three years. In most cases, the buyer has the option to buy the vehicle at the end of the lease term, but that requires a new financing agreement for the remaining value of the vehicle.
Financing a vehicle requires a capitalized principal request for the entire amount of the vehicle. This principal amount is spread across a longer term, which can vary depending on the decision of the borrower. For example, the financing of a vehicle purchase could be spread out over a ten-year term. When a vehicle is financed, the buyer has more ownership of the asset, though the title continues to remain in the lender’s name with a lien.
Regardless of whether a buyer chooses to lease or buy a vehicle, the down payment they pay goes toward reducing the capitalized financing principal they must request. Any other capitalized cost reduction will also be treated the same way, such as a rebate or trade-in. In general, the capitalized cost reduction will help to lower the amount of the monthly installment payments they will owe.
The benefit of an optional down payment will vary by situation. Installment payments for leased vehicles are generally said to be lower because the principal is less, but these payments are also usually divided over a shorter time frame, typically three or four years. Purchase financing is often said to have higher payments, especially for a new car, since the buyer pays the total new car sticker price, but these payments can be spread out over longer periods of time, possibly ten years. In both leasing and buying, a down payment will reduce the principal and monthly payment for the buyer. This means a lower interest expense.
Leasing and buying come with their own special considerations aside, which may also influence the amount of down payment a buyer is willing to make. Loss of equity can be a big factor in buying a vehicle, especially a new vehicle. The more you drive a vehicle the lower its open market value becomes. Paying more upfront on a vehicle can help manage equity concerns if a buyer is looking to trade in the vehicle before the financing has been paid off. Some buyers may like the leasing option better because they have the freedom to obtain a new car after three years. If returning the vehicle after three years is the plan, then the equity is not a big concern. Some buyers may be planning to take the buyout option at the end of a lease term. These buyers may like having lower payments from a capitalized cost reduction because of the bypassed interest and ability to save for another down payment when taking the buyout option.
Capitalized cost reductions help reduce interest expenses from loan agreements.
Many special considerations can arise in commercial vs. retail financing scenarios. In general, the top reason for making a down payment is to reduce the amount of financing needed, which reduces the total interest owed.
Businesses also have the option to lease vs. buy an asset, which can create different balance sheet reporting requirements. If a business is buying an asset through debt financing, they may need to post both loan payments as expenses against the loan received as well as depreciation expenses against the carrying value of the asset. In a leased asset scenario, businesses may not need to depreciate an asset that is leased because its asset recognition is accounted for differently. All of these considerations can potentially factor into the amount of money a business may choose to make as a down payment for purchasing or leasing a new asset.
Correction—July 7, 2022: A previous version of this article incorrectly stated that in a lease contract the capitalized principal is based on the value of a vehicle's appreciation. In fact, the capitalized principal is based on the value of a vehicle's depreciation over the term of the lease contract.