After housing, transportation is the next biggest expense for many people. So naturally it is a great idea to try to minimize the amount of money you’re laying out in order to drive your car. Two common ways of getting a car are through financing the purchase of the car, and by leasing. Financing and leasing sometimes get confusing, and it can be hard to tell which method is costing you more money in the long run. The purpose of this article is to clear up the difference between leasing and financing the purchase of a car, and to determine which is a better deal for you. Nobody wants to pay more than they have to for their car, so it’s important to know the differences.
Let’s start with a spoiler: I strongly believe that the very best way to get a good car, and spend the least amount of money possible, is to buy a reliable used car and pay for it in cash, rather than financing or leasing.
When you finance or lease, it’s very easy to justify getting a much more expensive car than you need, because the monthly payments make the cost seem manageable. “I can afford the monthly payments” is a phrase that will get you into big trouble when you are buying a car (or anything else for that matter).
The biggest way that paying cash saves you money is not by avoiding the interest and fees that you will pay with financing or leasing. The most significant way that paying cash saves you money is by forcing you to be realistic about what you can afford.
It’s easy to sign an agreement for a $500 monthly payment, but it’s not so easy to write a check for $35,000 all at once. A good used car would probably start to look a lot better if you had to shell out all that money at once. Forcing yourself to pay in cash is a great motivator to pick a car you can actually afford.
But enough about paying cash for cars, because the reality is that, unfortunately, not too many people do it. So we need to talk about the other ways of getting a car: financing and leasing.
When we talk about financing in this article, we’re talking about buying the car by taking out an auto loan. The important thing to stress here is that when you are done with your loan payments, you OWN the car. This is the main point that differentiates financing from leasing.
In addition to paying for the car itself, you will pay interest on the amount you owe on your loan every month. Depending on your credit score, your annual interest rate on a new car can vary from around 5% or less, all the way up to over 25%.
The interest you pay really ends up adding a lot to the price of your car over time. You can use an auto loan calculator to see how much interest is going to cost you over the life of your loan.
So you can see that overall, financing a car is pretty simple to understand. It works pretty much like any other loan. It’s easy to see what you are paying for and what you are getting. Now as we move into leasing the situation gets a little more complicated and less transparent.
While leasing a car, you make monthly payments for a predetermined period of time, usually 3 years, for the privilege of driving the car. Lease payments are typically considerably lower than the payments for financing a car purchase, which can make leasing look attractive. Because of the lower monthly payments, leasing looks very affordable on the surface, but if you dig a little deeper, leasing starts to lose some of its initial appeal.
The most important difference between financing and leasing is that when you lease, you are not moving toward owning the car. At the end of the lease you have nothing at all to show for it – after paying your 3 year lease, you don’t own anything.
WHAT ARE YOU BUYING WITH A LEASE?
So if you are not paying for any ownership of the car during a lease, what exactly are you paying for? Is a lease just a 3 year car rental? Well, sort of, but not really. When you lease, you are buying something, it’s just not something that has any value when your lease ends. You are buying the depreciation of the car during the time you are leasing it.
Depreciation is the progressive loss of value of a car over time. A car takes its greatest depreciation hit in its first year: a car loses about 20-30% of its value by the end of the first year. After that, a car loses about 15% of its value each subsequent year. So cars depreciate fastest in the first few years. After 3 years (the typical lease term), most cars have lost about half of their original value! This steep depreciation during the first 3 years of the car’s life is the main thing you are paying for in a lease.
Depreciation is a big downer when you buy and own a car. Nobody likes to think of half of the value of their car being gone after 3 years. But at least when you buy a car you can get beyond those years when the depreciation curve is the steepest, and get the juicy flat part of the depreciation curve, where you can continue to own and drive your car without it losing value too quickly anymore. And if you want a newer car at some point, you actually have a car that you can sell to defray the cost of a newer one – this doesn’t work with a leased car since you never own it.
Avoiding depreciation is, of course, the main reason for buying used cars. You can save a lot of money by getting a car that is several years old, because half of its original monetary value has just vaporized during that time. And now you don’t have to pay for all of that frustrating depreciation. Whoever bought the car new already paid for it.
Okay, so you have to pay the depreciation when you lease a car. But wait…there’s more. When you lease, not only are you paying for the depreciation, you are also paying interest, and a whole bunch of fees. So to make sense of all the charges on a lease, we’re going to go through the typical charges you will find on most leases, and define what these charges are. Leases vary, but you will find these items on most conventional leases.
THE MONTHLY PAYMENT
In order to understand how we arrive at the monthly payment, there are a few terms that must be defined.
- Gross Capitalized Cost (gross cap cost) – this is the negotiated price of the car plus any fees that will be rolled into the monthly payment.
- Net Capitalized Cost (net cap cost) – the gross cap cost minus any payments/credits that reduce the gross cap cost. Payments/credits that reduce the cap cost are the down payment, credit for a trade-in, or rebates.
- Residual Value – the calculated value of the vehicle after the lease term. In a 36 month lease, the residual value is usually somewhere around 50% of the value of the new car. The residual value is determined by a formula for each individual type of car.
- Money Factor – this is basically just the interest that you are charged on your lease and will vary depending on your credit score (link to credit article). The money factor is expressed as a decimal and not a percentage. To convert your money factor to a conventional interest rate (APR), you need to multiply the money factor by 2400. If your money factor is .0025, then your interest rate can be calculated as follows: .0025 x 2400 = 6%.
- Depreciation – the net cap cost minus the residual value. This, along with interest, is what you are paying for over the course of your lease.
The monthly payment is made up of the depreciation cost, the interest cost, and sales tax divided by the number of months in your lease.
Acquisition fee – charged for administering the lease. Approximately $400-$900.
Disposition fee – Charged to clean up and sell your car after the lease ends. Approximately $300-400.
Security deposit – This fee is refundable unless you have unusual wear and tear on your car, or are above your mileage limit. You can sometimes negotiate this fee off of the lease. The security deposit is usually approximately equal to one lease payment.
Excess mileage – If you exceed the allowed mileage on your lease, you have to pay for each extra mile you drive. The fee is around 20 cents per mile, but can be higher or lower depending on the type of car.
Purchase option fee – if you decide you want to buy the car after your lease is over. You have to pay a fee just to buy the car you’re already driving. This fee is usually a few hundred dollars.
Excessive wear and tear fee – If you return the car with what is considered by the dealer to be “excessive wear and tear”, you are charged a fee to repair the wear and tear. This wear and tear includes scratches, dents, stains etc.
Termination fee – if you end your lease early, you are charged a steep penalty for doing so.
THE CATCH 22 OF LEASE MILEAGE
Let’s talk about an issue with the allowable mileage. Your lease includes a specific number of miles that you are allowed to drive during your lease term, generally about 12,000 miles per year are allowed, so that’s 36,000 miles over the 3 year term. If you go over that mileage you get charged for every additional mile you drive.
Unless you really hit that allowable mileage on the nose, you are paying too much whether your mileage is too high OR too low. From what I’ve seen, it is typical to be charged around 20 cents per mile above the mileage limit, but the charge can be higher or lower depending on the car. More expensive cars usually charge more per mile. If you go over the limit by 5,000 miles, which you can do very easily over the course of 3 years, you would get hit with a $1,000 charge! Ouch.
But you are also getting penalized if you do not reach the allowable mileage. If you return the car with fewer miles on the odometer than the mileage limit, then you paid for miles you didn’t use. Your lease payments were based on 36,000 miles, so that’s what you paid for. If you don’t use all the miles, don’t expect a refund. So you get hit whether your mileage is too high or too low.
FINANCE VS. LEASE EXAMPLES
All this talk about fees, mileage, interest, money factor etc. is all well and good, but it’s a lot more helpful to see actual examples. I contacted a local car dealer and got current leasing and financing terms for a new Honda Accord. The car is currently being offered at that dealer at an MSRP of $24,800, so that’s the figure we’ll base the car costs on.
The monthly lease payment for this car is $199, while the monthly payment for financing the purchase of the car is $430. On the surface, you can see why leasing looks like an attractive option. But after actually running the numbers over a longer period of time, you can start to see the real picture emerge.
EXAMPLE #1: The first scenario will be the cost of driving a Honda Accord for 9 years.
Lease: If you lease, you will do three consecutive thirty-six month leases. Each 36 month lease costs $10,013 (including fees, interest and factoring in the required down payment) for a 9 year cost of $30,039.
Finance: If you buy the car through financing, with a 5.9% interest rate for 60 months and a down payment equal to the required lease down payment, your total cost for the car will be $28,299. But, remember you BOUGHT the car, so you now have a car with value that you can sell or trade in next time you buy a car. The value of an equivalent 9 year old Honda Accord is about $4,600, so we’ll subtract that from your cost for a total 9 year cost of $23,699.
So over 9 years, buying this car through financing is less expensive by $6,340. That’s a lot of money, but leasing might seem like it’s worth the cost for the pleasure of always driving a new car, if that’s really important to you.
In the next example, we’ll stretch the timeline out to 15 years to get an idea of how you really start to feel the pain when leasing for a long time.
EXAMPLE #2: Same car, a Honda Accord, but now we’re going to be driving it for 15 year before buying a new car. This is an entirely realistic lifespan for an Accord.
Lease: Now you’re going to do five consecutive thirty-six month leases. Each lease term still costs $10,013. So your 15 year cost is $50,065. Yikes! That’s a lot to spend to drive a car worth less than half that much when it’s brand new.
Finance: the cost of the car is the same as in example #1 ($28,299), because after the first 60 months, you own the car and don’t have to continue paying. However, the resale/trade-in value of your car after 15 years is less, only $1,400. So if you buy the car through financing, your total 15 year cost is $26,899.
So as you can see, over a longer time period like this, you basically are paying double if you lease the car. Is it still worth it? Maybe, but definitely not for me.
A lease will have a lower monthly payment than if you purchase a car by financing it. But leasing is much more expensive in the long run, since your monthly payments never end, and you never own the car. As you can see from the examples above, every 15 years, you pay approximately double for your car costs. That’s a huge price tag over the course of your life behind the wheel. The benefit of leasing is that you always have a fairly new car to drive, but you pay for that luxury in a big way.