In most cases, the most economical choice for owning a car is to buy one secondhand and drive it for years. However, there are many people that would rather drive a new car, and deciding whether to lease or buy a new car is an important decision. The first step in making this decision is understanding the difference between leasing and financing a car.
Leasing Versus a Loan
Leasing is just one way of financing a car. A lease payment usually consists of three parts - depreciation cost, finance charge and sales tax. The depreciation cost is based on the value lost on the car during the lease term. It is estimated by the manufacturer and is based on brands and models but are consistent and relatively accurate across the dealers. It is usually not something you can control. (For more, see: 4 Ways to Get the Best Deal on a Car Lease.)
A finance charge is the interest you pay on the money that the leasing company used to buy the car from the dealer. It is calculated differently by using money factors rather than interest rates on an auto loan but the concept is similar. In most states, you only need to pay sales tax on your lease payment rather than the total price of the car.
Most people are familiar with how an auto loan works. Just like a mortgage, a monthly payment includes principal and interest. The biggest difference compared to a lease payment is that your principal is based on the selling price of the car rather than the estimated depreciation amount alone. Whether you are leasing or financing a car, the depreciation amount is same. Most of the other parts of your principal will be used to build up the equity in your car. The rest of the principal is sales tax. You are paying it every month as part of the monthly payment.
Once you understand the difference between leasing and financing a car, consider these questions before making a decision about what choice is right for you.
Do You Want to Customize Your Car?
If the answer is yes, you would consider buying as your first option because you cannot make any changes to the car that you lease. When you lease a car, you need to get rid of all or at least most of your modifications and customization when you return it. The bottom line is that you do not own the car during the lease term.
Do You Prefer a Lower Payment or Saving More in the Long Run?
Provided that the other factors remain the same, lease payment is always much less than loan payment because you are only paying the depreciation cost and partial sales tax. However, it will cost you more in the long run because your payment will never end if you keep leasing. If you need a low monthly payment to get extra cash flow, you should consider leasing. (For more, see: When Is Buying a Car Better Than Leasing?)
To keep my monthly expenses low, I leased a car with $0 money down when I got my first job because I didn’t have much savings at that time. But we decided to purchase a new car for my wife early this year because we plan to keep the car for at least five years. Also, we would like to get rid of any car payment in five years to qualify for a home mortgage.
Are You Planning to Get a New Car Every 2 to 3 Years?
If the answer is yes, it may be the best option for you to lease a car due to the lower monthly payment mentioned above. Provided that everything else remains the same, the overall cost of leasing or financing should be similar, assuming the lessee returns the car at the end of a lease and the buyer sells the car at the end of a loan. The cost of leasing sometimes may be a little higher due to the additional acquisition and disposition cost. However, the actual net cost could be lower if you invest the difference between the lease payment and the loan payment every month wisely.
Do You Use the Car for Business?
If so, you may be able to deduct more auto expenses as business expenses by leasing. The tax rules related to this are complicated and beyond the scope of this article.
Before Making a Final Decision
Have you decided already? There are still several things you should know before making your final decision. (For more, see: When Leasing a Car Is Better Than Buying.)
- In general, don't be concerned about the potential charges on extra mileage and excessive wear and tear. This will cost you money whether you lease or buy a car.
- The insurance premium for a leased car is usually higher than a financed car with the same coverage. The actual difference is based on the brand and the model of the car.
- A leased car usually requires a higher minimum amount of insurance coverage. However, you should not decide on insurance purely based on the price. The most important thing is to get the right amount of coverage.
- You may have to pay some additional fees associated with a lease, including an acquisition fee when you enter the lease and a disposition fee when you return the car. The amount is usually a couple of hundred dollars each depending on the brand and the model of the car.
- The lease transfer market is making things easier for those people who have to get out of their lease early. However, it is still not wise to lease a car if your personal situation is not stable enough to keep the lease to the end due to transfer hassles and fees.
Some Final Tips
I hope that you are now informed and ready to make a decision. Before you go to the dealer, here are some final tips.
Get an idea about what other people are paying for the same car at edmunds.com or truecar.com. Whether you decide to lease or buy a car, the most important thing you should care about is the price of the car. Do not get intrigued by a “special” deal with very low monthly payment. Read the fine print. I bought a new car early this year at a price about $5,000 or 10% below the sticker price.
With current low interest rate environment, I recommend getting your down payment as low as possible if you could afford a higher monthly payment. If you invest the money that you save from the down payment, you should be able to generate a higher rate of return in the long run.
It's not necessary to get your car loan directly from the auto company. The interest rate that the auto company provides you is usually not as competitive as what you could get from a third-party lender, such as credit unions. However, the auto company sometimes has a special financing deal with a 0% interest rate. You should definitely take advantage of it. I initially got the loan on my new car with 3.9% interest rate from the auto company because they waived my first payment. Then I shopped around and refinanced it through a credit union with a 2.49% interest rate. My monthly payment went down by more than $60/month for the same 60-month loan.
The Bottom Line
Understanding the difference between leasing and financing a car is the first step in deciding between the two. Answering the questions above will help you make a final decision. (For more, see: 10 Tips for Buying a Car Online.)