The two ways to finance a car are to get a traditional auto loan or a lease on a vehicle. But which is the better option? You don’t actually own the vehicle with a lease, and it’s generally more costly over the long term. But certain people can do much better with this type of payment structure.
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A lease lets you use the vehicle for a set amount of time with a set amount of mileage in exchange for monthly payments. When you lease, you are essentially paying for the depreciation in the car’s value while you use it. Both buying and leasing a car involve a serious financial commitment, but leasing a car involves a much shorter time commitment. However, at the end of the lease, you don’t own anything.
|Less money is needed to get a better car||More money is required to get a car|
|The lease cycle means endless commitment||You own the car after financing|
|You can’t sell it, and it can be hard to get out of a lease||You can sell the car whenever you want|
|You can get a tax break, but it’s more expensive over time||It’s cheaper over time|
|You can upgrade to a new car more often||No worries about mileage or minor damage|
|You need great credit||You may be able to get a loan with bad credit|
|You must keep the vehicle pristine||You can use the vehicle how you want|
Advantages and disadvantages of leasing
The prevalence of leasing has increased over the past few years, and it now makes up a significant portion of all new car sales. There are some clear advantages to leasing a vehicle.
“Probably the main benefit to leasing is a lower payment,” says Jerry Love, a member of the National CPA Financial Literacy Commission. “If you plan to keep the car only a few years — say three years max — then leasing allows you a smaller payment, and you don’t have to worry about the trade-in value.”
Advantages to leasing a vehicle
- You don’t need to worry about repairs. The vehicle you get is brand new, and the warranty covers all repairs.
- Scheduled maintenance is included in many leases, which can help lower monthly transportation costs in your budget.
- You can get a better car for the money because you are only paying for the depreciation of the vehicle. A lease payment often means you pay less than what the monthly payments on a loan would be. Therefore, you can get a better car for the same money.
- You may get significant tax advantages. For example, business professionals can deduct the cost of a lease as long as you use the vehicle for business 50% of the time or more.
- You love getting new cars. If you like changing cars often and don’t want to keep a vehicle beyond a few years, leasing can be a good option.
Disadvantages to leasing a vehicle
- It can be more expensive overall. The depreciation you pay for is the highest when a car is new.
- Mileage charges can be high. If you go over the mileage in the lease agreement, your costs can skyrocket quickly.
- There can be lots of hidden charges. Even minor dings that are typical when you have a vehicle or higher mileage will cost you.
- Leasing requires excellent credit. You usually won’t be able to get a lease without great credit.
- You’ll continually pay. You’ll always be paying for a vehicle, but you’ll never own one in the end.
Advantages and disadvantages of buying a car
Buying a car has some distinct advantages over leasing. David Walters, Certified Financial Planner™ and Certified Public Accountant with Palisades Hudson Financial Group states, “The longer you own your car, the more you’ll save buying versus leasing.”
Advantages of buying a car
- You can drive as much as you want. Leases limit you on mileage. While that might work for commuting, or even better if you work from home, you might want to take a short trip every now and then. With a lease, you may need to find another way to travel for longer trips.
- You’ll have less stress when you park in tight spaces. In the lease, the agreement typically calls for the car to be returned in the same exact condition. But that rarely happens. Real-life happens, and over the course of a 3-year lease, a car can get some dings and dents. That can be costly when you return the leased car.
- You eventually own the vehicle. With a good loan of five years and less, you may have a positive value on the car, and you get to keep the vehicle at the end of the term.
Disadvantages of buying a car
- You will generally have a longer commitment. While you can get a loan for as little as 36 months, the average loan term is 69 months. With longer-term auto loans, you can end up underwater, where you owe more than the car is worth. Many people also experience life changes in seven years. Your car might become obsolete if your life situation changes.
- You’re responsible for repair costs. Leasing is a short-term commitment and covers the warranty period of a vehicle. When you own the car, you’ll experience most of its lifecycle out of the warranty period, and some of the repairs can become expensive.
- You may not have the latest technology. Better safety systems and hybrid power trains are experiencing rapid growth. Five years from now, the car you buy may not be as safe and fuel-efficient as the new one that you can lease.
Two types of car leases
There are different types of leases; the first is called a “closed-end lease,” the other is an “open-end lease.” Each has advantages and disadvantages. Federal law requires that a dealer clearly state which type of lease you get.
In this lease, sometimes called a “walkaway lease,” the leasing company is responsible for the reduction of the car’s value at the end of the term due to residual values. It can be an excellent advantage to you, especially if the type of car depreciates quicker because of market values. You can still get charged for extra mileage, damage, or wear and tear, but that is it. If the car depreciates less than what was initially stated on the contract, you can benefit and buy out the lease.
For example, if you lease a car that costs $20,000 and at the end of the lease, the market value is $12,000 but was projected to be $14,000 (in the lease agreement), you do not have to make up the $2,000 difference. After paying fees for extra mileage or any damage, if applicable, you’re done and can walk away.
You typically can buy the car at a price set when the lease begins. Using the same example, since the market price is lower than what the lease estimated, it’s not in your interest to purchase the vehicle. But if the market price was $16,000, you would be getting a great deal by buying the car at $14,000.
In this type of lease, you are responsible for the changes to the residual value. Like the closed-end lease, you are also still responsible for any damage and extra miles driven because those things affect the car’s value.
The difference with this type of lease is that regardless of the damage and excess mileage if the market price of the car goes below what was written at the time of the lease, you are obligated to make up the difference. Typically, this type of lease is used by larger businesses.
Using the same numbers from the example above, you (or your business) would be required to pay an extra $2,000 because the lease factored in $14,000 instead of $12,000.
Interest rate vs. money factor
When you buy a car, you get quoted a specific interest rate. But when you lease a vehicle, you’ll get quoted a “money factor.”
What is a money factor?
Most people are familiar with the term APR or annual percentage rate. When you purchase a car, a house, or use a credit card (and don’t pay it off right away), you must pay interest charges in addition to the principal of the loan. The principal of the loan is the amount you took out, not including interest charges.
But leasing works differently. In a lease, there is no APR; instead, you are paying a different financing charge known as a money factor. The money factor is sometimes called a “lease factor” or “lease fee.”
How is the money factor in a car lease calculated?
The money factor is a method for determining the monthly charges of the lease. The equation for the money factor considers the rate of depreciation, the interest rate (determined by your credit rating), and sales taxes. The result of that equation is what you will pay on a lease. It’s comparable to an APR on a loan. The money factor is usually shown as a small decimal. You can and should negotiate on the cost of the interest rate part of the money factor.
While some may think this is a trick to hide the actual cost of the payment, remember that you are financing the depreciation when you lease. Lease payments have three parts, interest, taxes, and depreciation, all of which have to be factored into the lease amount. Note that you can pay the sales tax upfront in some states, and there are no sales taxes in a few states.
How can I compare the money factor to an APR?
To make sure you are getting a good deal on your lease, you need to understand the equivalent APR before you sign the lease. Fortunately, you can do some simple math and find the APR quickly. All you need to do is multiply the “money factor” by 2,400. For example, if you know your money factor is .003, you would multiply it by 2,400 to get the equivalent APR rate. In this case, your interest rate would be an equivalent 7.2% APR.
You want to know the equivalent APR before you sign the lease and compare it to a conventional loan. That way, you can make sure you’re getting a good deal.
Is a lease buyout a good idea?
Leasing with the intention to buy can be an excellent option to get your car for a relatively low up-front payment and reduced monthly costs. But the process is not without its complications. You’ll have to look at the market price of the car.
If the market price is higher than the lease agreement stated, you’ll come out ahead. If it’s lower, then you won’t be getting a good deal. You will also need to look at the wear and tear you put on the car and mileage, especially if you put extra miles beyond the lease agreement. Ask yourself if the vehicle is worth buying.
You may also need to finance the car. If you’ve been on time with the lease payments and your credit is good, and you should be able to get a loan. Make sure to keep a good credit score during the leasing process.
Be aware that with a lease buyout, you pay sales tax twice. Once when you start the initial lease and a second time when you purchase the car.
Buying out your lease in 2021
2020 and 2021 have been challenging years for many people. But if you’re in a lease right now and the lease is about to expire, you are in for some good news. Since inventory in the used car market is so limited, it’s in the best interest of many consumers to purchase the car they leased if they have that option. The residual value of a leased car is much higher at the moment, and the vehicle may be worth more than what was put into the lease documents.
Leasing offers an alternative to long loans
Leases typically run only up to 36 months. But, car loans are steadily getting longer. Some car loans can go as long as 84 months or eight years. While this may help with a lower monthly payment, you pay more in interest and repair costs (most warranties run out after three years). You can also wind up owing more than what the car is worth. In fact, you’re likely to sell your new car in about six years, on average.
In many cases, you may end up selling the car before you have the loan paid off. You won’t be able to get any money on your trade-in and could have to spend money to pay off the auto loan that you would have used for your down payment. This can lead to a cycle of bad debt.
This example shows when it may be better to lease instead of taking out a long-term loan. Let’s say that the car you’re looking at has a price of $25,000, and you have $1,000 for a down payment. We’ll factor in a 4.5% (equivalent) interest rate and a 40% depreciation in value in 3 years, which is average. In three years, the vehicle will be worth $15,000.
For a 36 month lease, you will be paying $345.74 per month with $1,000 down at the time of signing. After three years, you would have paid $13,446.64 for a car that is brand new and doesn’t need any repairs since those are covered under warranty. After the lease, you won’t own the vehicle, but you also won’t have negative equity on a car.
If you were to buy the same car at the same price with an eight-year loan, you would be paying $333.60 per month. You would pay a total of $13,009.60 for the first 36 months, including a down payment of $1,000. You’ll have a vehicle worth $15,000 at that time, but you’ll still have 48 payments left. At this point, you owe more than the car is worth, and your debt is $16,595.52.
By contrast, with a more reasonable five-year loan, the payments will be higher; you’ll be paying $400 per month. However, after spending $15,400 for 36-months, including the $1,000 down payment, you will only owe $9,600. The value of the car would be more than the remaining balance on the loan, should you need to sell.
Why financing may offer a better option for many
Leasing has some distinct advantages, but so does financing. You’re far more likely to be approved for financing even with bad credit. As long as you make your payments on time, a secured loan like an auto loan can be a fantastic way to improve your credit rating. And while cars depreciate in value quickly, you will have an asset once the loan is paid off. Additionally, you can customize your car and add or take off anything you want.
Things to consider before you sign a lease
Article last modified on October 11, 2021. Published by Debt.com, LLC