So, you’re thinking about getting a new car. You’ve decided that depreciation be damned, you want the most updated, fancy, shiny vehicle on the market. Now you’re stuck on whether to finance that new car or lease it. First, let’s look at the differences, what their pros and cons are, and then I will give you my opinion, because that’s really why you’re here.
The term financing is simply a way to say, “a loan” or “borrowing someone else’s money”. If you are not familiar with financing, the equation goes something like this: you want a thing, but you do not have enough money to buy the thing, so a company or a bank offers to buy that thing for you in return for a promise or contract that you will pay them back over a specified period and at a specified level of interest.
This allows you to buy an expensive item without saving up and the bank or company makes money off the interest so they can loan your money out to other people and make more money. Make sense?
Interest, simply put, is the cost of borrowing money. Interest works against you when you borrow someone else’s money, but it works in your favor if someone borrows money from you, such as when you invest.
Okay, now you may be thinking, “that sounds like some sort of Ponzi scheme BS, right there.” Maybe it does, and it certainly sucks to pay extra money in interest. However, for some, the immediate gratification of purchasing an asset through financing is worth the long-term cost of interest, and it can help boost your credit score assuming you make regular payments.
Specifically, financing a car means you borrow money from a bank to buy the car from the dealership, and in return, you are expected to make monthly payments for several years until you own it. Typically, new car loans are contracted for 60-72 months. Interest rates can vary, but occasionally you can find a zero-percent interest deal, which means you don’t pay extra over the total vehicle price, assuming you pay it off within the specified period.
Leasing is more complicated but also more tempting than financing. What consumers see is the vastly reduced monthly cost of operating a vehicle compared to financing. Think of it as renting an apartment instead of buying a house. When you rent an apartment, you sign a lease agreement. This is a similar concept.
Instead of getting a loan from a bank to purchase a car and then paying the bank back, in a lease you are typically paying the dealership or a specialized finance company.
But, and this is the major difference between financing and leasing, instead of gaining equity (ownership) in the car, with a lease you are essentially paying for the privilege of driving that vehicle. At the end of the lease term, which is typically 36 months, you will either sell the car back to the dealership or buy it out of the lease if that is an option.
You might think this doesn’t sound so bad. Lower monthly payments, the car is always under warranty, and you have the option to buy it if you really like it.
What is lesser known, though, is that during the term the lessee (that’s you) is paying the depreciation between the purchase price and the price the manufacturer is willing to buy the car back at the end of the term. This is called residual value and is predetermined when you sign the lease. In addition, you are paying interest (called the money factor) on any cash that was borrowed from the dealership or financing company to cover the gross capitalized cost, which is the combination of agreed upon vehicle value and service fees.
Sounds complicated? Yeah, I agree.
Let’s say you want a brand-new car, and that car has a gross capitalized cost of $40,000. You put $4,000 down from a trade in, which brings your gross capitalized cost down to $36,000. In three years, the manufacturer is willing to buy that car back at $22,000. Over three years you will pay $14,000 in depreciation plus whatever interest is running on the $36,000 you borrowed from the finance company to get into the lease. Sometimes you will be required to purchase gap insurance (if it’s not provided for free) to cover the difference in what you owe on the lease and actual value of the car in the case of a total loss accident or a stolen vehicle. There is also a mileage cap per year, and you will be charged monumental fees at the end of your agreement if you exceed it. You can also get charged for wear and tear if you return the car in poor condition.
Remember, a manufacturer is assuming that they will be buying a leased vehicle back from you at the end of the term, which means they are going to make sure the lease is a better deal for them than it is for you.
This Authors Opinion
The biggest downside of leasing is the lack of equity in whatever vehicle you are driving. Some would say they don’t want equity in a car because it is a depreciating asset, and they have a point, but when you must shoulder the depreciation anyway, you might as well get a car out of it.
Proponents of leasing also like the idea of always being able to have a new car that is under warranty. This seems to be the most legitimate argument in favor of leasing, as the biggest risk of purchasing a used car is maintenance.
Leasing also reduces hassle in the short term by guaranteeing you have somewhere to offload your vehicle when you’re done with it. The question is, what do you do after you have offloaded that vehicle and need another one?
It seems incredibly easy to get into a cycle of leasing, making monthly payments, and never truly owning a car. This can be likened to long-term renters. Sure, they always have a place to stay and maybe it costs less than a mortgage, but they never end up owning a house, which is one of the best ways to build wealth. While cars are not exceptional wealth-building tools, never gaining equity is a good way to stay house poor.
Ultimately, leasing can be a good short-term tool for someone who needs a reliable car for low monthly payments and doesn’t have the time for or can’t afford surprise maintenance. However, a person who continuously leases risks relying on continuous income to make those monthly payments, instead of working towards owning a vehicle outright. This can become a problem if lifestyle drastically changes, jobs are lost, or a second or third car is needed.
If someone wishes to lease a car, I suggest they treat it as an apartment rental – a short term solution that prevents them from accumulating too much debt and who’s lower payment allows them to save with the goal of purchasing a car after the lease is over. It’s not easy being a financially conscious car guy, but it can be done.