New Wheels: Lease or Buy?

Buying a car can be overwhelming. In fact, the pleasure of getting a new car can be quickly clouded during the financing decision-making process and price negotiations. Besides price haggling, many car shoppers are stymied by the decision to lease or buy. This article will compare the two options and hopefully help you decide which financing decision is right for you.

Buying a Car

Buying a car is the most straightforward way of obtaining one—you either pay cash or take out a loan to cover the cost. But that doesn't mean the benefits will outweigh the drawbacks for your particular situation.

The Benefits

By far, the greatest benefit of buying a car is you will actually own it one day, which also means you'll be free of car payments until you decide to buy another one. The car is yours to sell at any time, and you are not locked into any type of fixed ownership period.

When you buy a car, the insurance premiums are typically lower than if you lease. In addition, by owning a car, you're free to rack up the mileage without  worrying about financial penalties or restrictions.

The Drawbacks

The most obvious downside of owning versus leasing is the monthly payment, which is usually higher on a purchased car. Additionally, the dealers usually require a reasonable down payment, so the initial out-of-pocket cost is higher when buying a car.

Presumably, as you pay down your car loan, you have the ability to build equity in the vehicle. Unfortunately, however, this is not always the case. When you purchase a car, your payments reflect the whole cost of the car, usually amortized over a four- to six-year period. But depreciation can take a nasty toll on the value of your car, especially in the first couple of years. As a result, buyers with down payments can end up financing a considerable portion of the car and even find themselves in an "upside-down situation," in which the car comes to be worth less than what the buyer stills owes on it at a given time. (To learn more, see: Buying A Car: The Worst Investment?)

Like the monthly payments of a mortgage, monthly car payments are divided between paying principal and interest, and the amounts dedicated to each vary from payment to payment. In the first years of your car loan, the majority of each payment goes toward interest rather than the principal. During this time, most new vehicles also depreciate 20 to 40%. The loss in equity is a double whammy: your car depreciates dramatically, and because the monthly payments you've been making have mostly gone towards interest rather than the principal, you are left with very little equity in the car.

Leasing a Vehicle

For those who have never leased a car, the process can seem confusing and geared more toward business owners, who might deduct the expense, or individuals who simply can't afford car payments. But in reality, there are benefits to leasing a car regardless of your career or income status.

The Benefits

Perhaps the greatest benefit of leasing a car is the lower out-of-pocket costs when acquiring and maintaining the car. Leases require little or no down payment, and there are no upfront sales tax charges. Additionally, monthly payments are usually lower, and you get the pleasure of owning a new car every few years.

With a lease, you are essentially renting the car for a fixed amount of time (typically 36 to 48 months). Therefore, you pay only for the use (depreciation) of the car for that period instead of absorbing the full depreciation cost of the vehicle. Leasing a car will never put you in an upside-down position.

Finally, for business owners, leasing a car may offer tax advantages if the vehicle is used for business purposes.

The Drawbacks

By leasing a car, you always have a car payment because you will never actually own the vehicle. So if you don't like that prospect, leasing is probably not right for you. However, depending on your type of lease, when your lease term is up you may have the option of financing the remaining value of the vehicle, which mean you will own it when you finish making the loan payments.

The mileage restrictions of leasing pose another drawback. If you drive a great deal during the year, purchasing a car may be the better choice. At the very least, you will want to look into an open-end lease, which we discuss below. Most leases restrict your mile usage to 15,000 miles per year (sometimes 12,000 per year). If you go over your allotted miles, you'll pay anywhere between 10 and 25 cents for every extra mile, depending on your lease agreement and the type of vehicle involved. This penalty can leave you with a fairly large bill to pay at the end of the lease if you rack up a lot of extra miles. (For related reading, see: Extreme Commuting: Is It for You?)

Finally, insurers usually charge higher coverage costs for leased vehicles. However, depending on your age, driving record and place of residence, that additional cost may be nominal.

Words of Caution

A downside to leasing is you essentially pay for the most expensive years of a vehicle's life. The amount you pay to lease is the difference between the purchase price and the residual value, which is the predetermined value of the car at the end of the lease period. The residual value the dealer includes in your contract directly impacts your monthly payment.

When leasing, it's better to consider a vehicle retains its value and steer clear of cars with a high depreciation rate. Devious dealers may try to shift more of the depreciation cost onto you by embedding an unfairly low residual value.

Also, when entering a lease agreement, be aware of any clauses in the contract regarding additional charges for "excess wear and tear" or above-average costs for additional mileage. You want to minimize any surprise costs as much as possible. (For related reading, see: 4 Ways to Get the Best Deal on a Car Lease.)

Leasing Options

There are two types of car leases: closed-end and open-end. Closed-end leases allow you to walk away from the car at the end of the lease term. If you owe for any extra mileage or excessive wear and tear, this is when you'd have to pay for it.

With an open-end lease (also known as an equity lease), you must purchase the car at the end of the lease period for a predetermined amount. This is often the type of lease used by businesses or individuals who drive a lot. Most consumer groups suggest the closed-end lease is the best option because it poses less risk upon the expiration of the lease term.

The Bottom Line

The decision to lease or buy will always depend on your personal circumstances. If your objective is to one day be rid of car payments and you actually want to take ownership, buying a car is the best option. If, however, if your goal is to drive a new set of wheels every few years and minimize your monthly costs, leasing a car may be a good alternative. (To learn more, see: The True Cost of Owning a Car.)