LEASING VS. FINANCING A CAR

LEASING VS. FINANCING A CAR

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Leasing versus financing a car is always at the forefront for many households looking to obtain a vehicle today. Which one is the better option for you? 

While there may not be an obvious choice suitable for everyone, both options should be understood to make an informed decision. This article will lay out some leasing comparisons versus financing a car to help you make the best decision for your situation.

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First, note that paying for a car in full upfront is the cheapest option over the long-term. It is also quite simple and straightforward as you own the car immediately, and there are no further payments required except for the usual maintenance costs. In essence, it forces you to live within your means.

However, since few people are in a position of paying for their cars in cash, leasing and financing agreements provide a viable alternative.

DEFINITIONS

FINANCING: This is taking out a loan to purchase a car. The lender retains ownership until you make the final payment. That means that the lender can repossess your vehicle if you default on payments. At the end of a financing term, you own the car, and you get to keep it.

LEASING: This is renting a car from a dealer for a fixed period. A typical lease term would be between 2 to 3 years. Once the lease period ends, you can either return the car or buy it at a predetermined price, as defined in the lease contract.

To further understand leasing versus buying a car, let’s explore each option’s pros and cons.

FINANCING A CAR

PROS

  • A portion of each payment goes toward building equity in the vehicle. As such, financing will result in an asset at the end of the term.
  • There are no limits on the number of miles you can drive.
  • You can customize and modify the car to your liking without any restrictions or penalties  for doing so.
  • At the end of the financing term, there are no further payments, and you own the car.
  • It is the overall cheaper option if you plan to keep the car long-term.

CONS

  • The monthly payments are higher as they are calculated based on the vehicle’s full value and include both principal and interest.
  • A car is a depreciating asset that loses its value quickly. Most cars lose up to 60% of their value in the first three years. As such, it may be worth very little when you complete the financing term.
  • The maintenance cost may be higher once you pay off the car if full due to the car’s age. An older car has more wear and tear, and it may no longer be under a manufacturer’s warranty.
  • Typically, financing a car requires a larger down payment in the form of cash or trading-in another vehicle.
  • You may end up being upside down on the loan if you trade-in or sell your car before the financing period ends. That simply means that your loan balance may be higher than the value of the vehicle. In such a case, you may have to pay for the difference out-of-pocket or roll it into a new loan (which could keep you in a never-ending debt cycle).

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LEASING A CAR

PROS

  • The monthly payments are usually lower as they are calculated based on the car’s depreciation over the lease term (and not on the full price of the vehicle).
  • Typically, leasing a car requires a smaller down payment which includes the first month’s payment and a refundable security deposit.
  • Leased cars tend to be brand new. As such, you get to drive a vehicle with the latest technology.
  • There are fewer expenses as leased vehicles tend to be brand new with minimal wear and tear. Additionally, most arising costs would fall under the warranty provided by the manufacturer.
  • You are not responsible for selling or trading in  the car at the end of the lease term; simply return it to the dealership and walk away.
  • You can deduct some car expense from your taxable income if you use the vehicle for business purposes.

CONS

  • This option does not build equity, and you will not have an asset at the end of the lease term unless you choose to buy the car at the residual value stated in the contract.
  • If you choose to buy the car at the end of the lease term, the residual value may be higher than the market price. In such a case, you may want to return the leased car and buy the same kind of car in the market at a lower price.
  • The penalty for breaking a lease contract is quite steep and could amount to paying for the rest of the lease term.
  • Leasing offers less flexibility than financing a car. It requires a higher credit score and includes restrictions on customization, ride-sharing, and mileage. As such, you may be charged additional hefty fees for violating any restrictions.  The cost of going over the allotted miles is typically 20 to 25 cents per mile.
  • You may be liable for some costs not covered by your car insurance should you get into an accident before the end of your lease term. Obtaining Guaranteed Auto Protection (Gap) insurance can cover such discrepancy, but it requires a higher monthly fee.

BONUS: HOW CAR LEASE PAYMENTS ARE CALCULATED (**TECHNICAL!**)

Car lease payments are calculated based on the depreciation of the vehicle. Depreciation is the decrease in the value of a car during a lease term. 

Inputs used in the lease payment calculation include:

  • Manufacturer’s Suggested Retail Price (MSRP): This is the manufacturer’s listed price and is the starting point for negotiations with the dealer.
  • Discounts: Any rebates and incentives that can reduce the MSRP price.
  • Selling price: This is the price that you agree upon with the dealer, after negotiating down the MSRP and applying any discounts. Successfully negotiating down the selling price lowers your monthly payments.
  • Residual Value: This represents the value of the car at the end of the lease term. It is the amount the dealer expects to receive for selling the vehicle at the end of the lease term.
  • Depreciation: The value that the car has lost during the lease term.
  • Money Factor (or Lease Factor): It represents the financing charge that you would pay on a lease. Your credit score determines the Money Factor. The higher your score, the lower the money factor used for your lease payments.
    • You will find the money Factor expressed in decimal points
    • You can convert a money factor to an interest rate by multiplying it by 2,400
    • A money factor of 0.002 is equal to an interest rate of 4.8% (2,400 x 0.002)
    • If you have a high credit score, you can estimate an interest rate between 2% and 5%
    • With an average credit, your estimated interest rate would be between 6% and 9%
    • With a poor credit score, your estimated a interest rate would be between 10% and 15%
  • Fees: These are upfront fees that you would have to pay; similar to a down payment when you finance a car.

ILLUSTRATION

A car has an MSRP of $33,000. As the lessee, you manage to negotiate the selling price with the dealer down to $30,000. The car has a residual value of $15,000 and can be lease for three years (36 months). Your money factor is determined to be 0.00125, and fees of $1,200 apply to your lease.

Step 1: Selling Price + Fees = Capitalized Cost

$30,000 + $1,200 = $31,200

Step 2: Gross Capitalized Cost – Residual Value = Depreciation Amount

$31,200 – $20,000 = $11,200

Step 3: Depreciation Amount / Lease term (months) = Base Lease Payment

$11,200 /  36 = $311.11

Step 4: Capitalized Cost + Residual Value) x Money Factor = Rent Charge

            ($31,200 + $20,000) x 0.00125 = $64

Step 5: Rent Charge + Base Lease Payment = Pre-tax Lease Payment

            $64 + $311.11 = $375.11

You can find out the interest rate on your lease by asking your finance manager. S/he will likely provide you with the money factor, which you can convert to an interest rate by multiplying it by 2,400.

Since your credit score has a direct impact on your lease payments, you should be aware of your score to avoid any surprises at the dealership.

CONCLUSION

The decision of whether to lease or finance a car is personal and mostly depends on your preferences. I hope the information in this article will help you make a more informed decision the next time you want to get a car.

If you enjoyed this article or have any questions, please leave them in the comment section below! I’d love to hear from you! Also, please feel free to share this with anyone that may benefit from it as well.

“Motivation is what gets you started. Habit is what keeps you going.” ~ Jim Ryun

Financing vs Leasing a Car

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TAKE CONTROL OF YOUR PERSONAL FINANCES

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Ever feel like money just seems to slip through your fingers month after month? Our Monthly Budget Tracker will guide you to start making the most of every dollar. It’s a game changer—get it free for a limited time!

Nikki Kirimi

Nikki Kirimi is a finance professional (MBA, CPA, CMA) and the creator of Money World Basics. She enjoys acquiring and sharing personal finance knowledge to help people better their lives.