To lease or buy a new car? Both have their fair share of strengths — and drawbacks. Here’s how to choose the best way to finance your new vehicle.
What is a lease?
A lease is essentially a long-term rental. Even though the leasee (the person taking temporary ownership of the car) makes a monthly payment, they do not own the car. Instead, they sign a contract that lets the driver use the vehicle for a set amount of time and drive a certain amount of mileage. At the end of the leasing period, the vehicle is returned. Depending on the lease, or may have the option to keep the car (“buy out the lease”).
There are two different types of leases; a “closed-end lease” and an “open-end lease.” Each has advantages and disadvantages. Federal law requires that a dealer clearly state which type of lease you get.
How loans and leases differ
| Lease | Loan |
|---|---|
| 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
Leasing a car is a much shorter commitment than buying one. However, at the end of the lease, you don’t own anything. Leasing is also generally more costly over the long term. So is leasing a car a waste of money?
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.”
Typically, lease payments are lower than auto loan payments, making buying a car more affordable. They also tend to come with other concessions built into the contract that cover maintenance and other expensive car costs. But there are other advantages that aren’t just about a dollar amount.
- 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. This means free maintenance on issues big and small.
- You can get a better car for less money. Lease payments only pay for the depreciation of the vehicle.
- You may get significant tax advantages. 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 having the newest 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 that saves you the hassle of having to sell your old vehicle.
Disadvantages to leasing a vehicle
- It can be more expensive overall. Even though you’re only paying for the car’s depreciation, those costs are highest when a car is new. It’s possible to lease a used car, but it’s not as common.
- Limits to how much you can drive. This might suit someone who just commutes to and from work, or even better, works from home, but leases aren’t great for road trips or other unexpected excursions. 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 will cost you.
- Leasing requires excellent credit. If you have bad credit, a lease may not be the alternative you think it is.
- Lack of equity. Most leases are 2-4 years long. After all those payments, you won’t have anything to show for it.
Read More: Is Leasing A Car A Waste Of Money?
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 and require keeping close tabs on your odometer. There are no such restrictions with a car that you own, meaning less headaches and more freedom.
- 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 real-life happens, and over the course of a multi-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. In the same amount of time as a lease contract, you could’ve earned equity on a purchased car. Although it costs more money upfront, the car can later be sold to recoup some of those costs.
Disadvantages of buying a car
- It’s a longer commitment. The average loan term is 69 months.[1] Longer-term auto loans put you at risk of ‘going underwater’, where you owe more than the car is worth (the same thing can happen with mortgages on a house). Plus. many people also experience life changes in seven years and our car might become obsolete as 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 outside of that 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.
Read More: How to Buy a Car
Types of Leases
Closed-end lease
Sometimes called a “walkaway lease,” or “true lease”, in this type of contract the leasee has no obligation to purchase the vehicle at the end of the lease agreement. There’s less responsibility on the leasee — but also more restrictions.
First, let’s talk about the financial benefits of a closed-end lease. The biggest one is that the leasing company is responsible for the reduction of the car’s value at the end of the term due to depreciation. Here’s why that matters:
Dealerships determine lease monthly payments based on expected depreciation of the vehicle over the time that it’s being borrowed. If your leased depreciates more than the expected amount, the leasee isn’t on the hook for paying that differnce.
Say you lease a car that costs $20,000. It was projected to have a market value of $14,000 per the lease agreement, but ended up with market value of only $12,000. The consumer does not have to make up the $2,000 difference.
Another advantage? If you have the option of buying the vehicle once the lease ends, leasee’s can usually buy the car at the market value listed in the contract. Using the same example as above, let’s say that the opposite happened, and that the market price was $16,000 — $2,000 more than the estimated market value. You would be getting a great deal by buying the car at $14,000.
Open-ended lease
In this type of lease, the indvidual is responsible for the changes in the car’s residual value and if the market price of the car goes below what was written at the time of the lease, they are obligated to make up the difference. Typically, this type of lease is used by larger businesses rather than individual consumers. Open-ended leases are much more flexible and better suited for drivers that put on serious mileage.
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, 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.
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.[2]
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 most
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
Your budget should be considered before you make your choice. Specifically, how much can you afford each month for your car payment. Remember that you will not have a car with a lease after you are done, and with inflation, your next lease payment will be higher.
Take note of how many miles you drive in a month or in a year. Do you take road trips? Do you have a long commute? Is it possible that you might have to work at a location further away from your home? Leases will charge you hefty fines if you go over the mileage limitations. Before you lease, you need to understand your driving habits.
Loans are a long-term commitment, and your driving needs might change drastically in the next few years. You may need to change the type of vehicle you own. With a lease, you rarely can change your car; with a loan, you own the vehicle and can sell it anytime you want.
It’s challenging to get a lease with anything other than top-tier credit. Make sure your credit score is good before you consider leasing.
You can get significant tax deductions if you are a small business owner or self-employed when you lease. Remember you have to use your vehicle for business use at least 50% of the time.
Some people want the newest of the new and don’t want older cars. Leasing is a better idea for people who want to trade in their vehicles after three years.
When you return the leased car, it is supposed to be in pristine condition. But kids and animals can likely damage the inside of the vehicle, and you’ll get charged extra for that.
If you don’t have a set place for parking your leased vehicle, such as a garage, you are more likely to sustain damage from weather events and other nearby cars. Any damage on a leased vehicle will cost you extra.
Of course, you’ll pay for any damages that occurred during a lease, but understand that leasing companies often require higher coverage levels when you lease. You’ll also have to pay for GAP insurance, which you can get on your insurance. But that, too, will increase your monthly insurance costs. If your insurance is already high, it will be even higher with a lease.
Your lease is required to be maintained in excellent condition, which means you can’t skip the car washes, oil changes, and other maintenance items. Not that you should skip maintenance with the car you purchase, but at least there are no fines involved.
