The Implications of Leasing a Car
A Financial Tutorial for OnMoney.com
by Mouncey Ferguson
Rent or buy? Rent or buy? Rent, and walk away when catastrophe
strikes, but watch your money add up to nothing. Or buy, and put
your money where your mouth is, with all the concomitant loans
and interest. Which will it be?
Of course, it depends on what you’re buying. A house, after all,
can be a worthwhile investment. Houses last. It can go up in
value, depending on who moves in next door, and whether the
new metro stop is built across the street. It can also plummet if
the new thruway goes past your back door.
A car, though, is not an investment. It only goes down in value,
and usually fairly quickly. Ten years is the most you can ask
without major repairs. Twenty years and you’ll start to look like a
Beverly Hillbilly.
The long-term alternative to buying a car isn’t a three-year
contract with Avis, it’s a lease from a dealer. Leasing a car can
be a convenient way to keep yourself in a flawless new ride, but
it has plenty of drawbacks, too. You can end up paying a lot of
bucks for the privilege of passing one.
The New Deal
Today, more than a quarter of all new cars are leased rather than
bought, compared to a mere three percent ten years ago. The
reason is simple: the monthly payments are significantly lower.
You can lease a car for hundreds of dollars less than the monthly
cost of buying. But that doesn’t mean it’s a great idea.
How It Works
When you buy a car, you pay for the car. When you lease, you
pay for only the value that the car loses while you are behind
the wheel, plus interest on the car’s total value. At the end of the
lease you give the car back, and the dealer tries to get the rest of
his money out of the car by selling it.
To calculate your monthly payments, the dealership needs to
estimate what the car will be worth when you give it back. This
is called the car’s residual value. To compute it, dealers often
follow a simple formula which says that the car will be worth
two-thirds its value after two years, and just over half after three
years (most leases only last for two or three years). But they have
some freedom here. If they want to make the deal sweet for you,
they can pretend the car will be worth more when you give it
back than it actually will be. For instance, they’ll pretend that a
$20,000 Toyota will be worth $14,000 when they probably won’t
be able to get more than $12,000 on the street. They do this in the
hopes that you’ll end up racking up other fees and penalties that
will make the deal worth it for them.
You have some freedom here, as well: the freedom to bargain
down the sticker price, known in leasing circles as the total
capitalized cost, just as you would if you were buying. In fact,
when you go to lease a car, don’t tell the dealer you want to lease.
Tell them you’re buying, and only say the word “lease” after
you’ve agreed to a price.
Your monthly payment is composed of two parts:
- A monthly installment on the car’s total devaluation. To
figure this, you subtract the car’s residual value from the final
price that you agreed to, minus any amount that you pay up
front to reduce your payments. Then divide this figure by the
number of months that you’re leasing the car.
- Interest on the car’s total value, plus its residual value.
This is known as the leasing fee. You pay this because, in
essence, the dealer has loaned you this much money in the
shape of the car, and anytime someone loans you something
you can expect to pay interest. What makes it slightly more
complicated is that dealers don’t talk about interest, they talk
about the money factor. In the end, it’s the same thing. The
money factor will generally be a figure like .0032. You can
translate this into an interest rate by multiplying the money
factor by 2400 (i.e. .0032 x 2400= 7.68%). To figure out your
leasing fee, add the car’s value to it’s residual value, and
multiply it by the money factor.
Do the Math
Say you want to lease a $20,000 car for three years, and it will
be worth $11,000 when you give it back. The car’s devaluation
would be $9,000. Divide this by the 36 months of the lease, and
your monthly devaluation payment would be $250.
Compute your leasing fee by adding the car’s value, $20,000
and it’s residual value, $11,000, and multiplying it by the money
factor. $31,000 x .0032 = $99.
$250 + $99 = $349. Then add on taxes, and you’re basically
looking at $375/month for a $20,000 car.
Anything that you paid beyond this price would be fees. Make
sure that you understand and agree to these, because the dealer
may try to pad the deal with unannounced fees. The only way to
avoid this is by understanding the math. Don’t let them lose you
with smoke and mirrors.
Certainly $375 a month is hundreds less than you’d pay every
month to buy such a car. But that doesn’t mean it’s the right thing
to do, it just means it’s easier on your monthly budget. There
are advantages and disadvantages to leasing a car. Whether it’s a
good idea or not depends on your preferences, priorities, and cash
flow.
The Pros and Cons
By now, we know the major advantages: low monthly payments,
and low down payment, which allow you to drive a car you might
otherwise not be able to afford. You don’t have to sweat the
details of reselling it, and you don’t have to worry about going
“upside down” on it either, which means that the car’s street
value is less than the amount left on your loan.
The drawbacks are substantial, however. For one thing, at the
end of the term you’ve got nothing to show for the money you’ve
spent (the renter’s dilemma!). You’ve got to lease another car, and
the payments start all over again. There’s also generally a limit
on the miles you can drive it every year. If you exceed the limit,
you’ll have to pay a substantial rate per mile.
There are more arcane issues as well, which you should clear
up before you sign the lease. For one, it’s difficult to get out of
a lease once you’ve signed it, and the dealer imposes significant
penalties for doing so, making it smart only for people who
have extremely stable financial situations. Try to get a lease that
specifies a low early termination fee or, if possible, none.
Then there’s the problem with insurance. As we said, in order to
charge you lower monthly payments, the dealer will sometimes
estimate the car’s residual value above it’s eventual street value.
If you total the car, or if it’s stolen, though, your insurance
will only cover the street value. You’ll have to pay the rest
out of pocket. You can cover yourself with what’s called “gap
insurance,” but that costs extra.
People who use their car only for business. Leasing for
business can make a lot of sense because you can deduct the cost
as a business expense. You can deduct the expense if you buy the
car, too, but then you have to depreciate it.
People who just like luxury cars. Luxury cars often make
the best leasing cars because they maintain their value, so their
residual value remains high. Economy cars and fad cars lose their
value much more quickly.
On the other hand, if you’re the kind of person who foresees a
long-term relationship with your car, such as someone who can
do repairs, or plans to eventually pass the junker on to the kids,
then buying a car is generally worth it. Also, if you tend to cover
a lot of ground every year, or have a long car trip coming up,
leasing won’t be a good deal for you. The bottom line is this:
buying a car may be expensive, but in the end the car belongs
to you. Leasing frees you from many of the responsibilities of
owning a car (but not all—routine maintenance is still your
problem!), but it also frees you from the comforts and freedom of
ownership.
Tips if you do decide to lease:
-
-
-
Be sure you get a closed-end lease, which means that the
lease period is set in advance, and so is the residual value.
The dreaded open-ended lease means that the car’s residual
value is determined by the market whenever you bring the
car back, and you’d have to make up the difference between
what you’ve paid and what the car’s worth at that time. This
almost guarantees heavy fees at the end of the deal.
Pay the minimum up front. Some people are tempted to
decrease their monthly fees by paying a thousand or two up
front, but that’s putting a down payment on something you’ll
never own. If you drive it off the lot and straight into a tree,
whatever you paid up front is history.
Don’t lease beyond the car’s warranty. If you do, and you
could end up with hefty repair bills on a car you don’t own.
Never pay for optional equipment. Generally you’ll pay
enough to buy it, but you’ll have to give it back along with
the car at the end of the lease term.
Think about the end of the lease before you start. Find
out what the excess mileage fees could be, how big the wearand-tear fees will be, and what kind of routine service you’re
expected to pay for. In addition, find out what charges, if any,
you’ll be expected to cover if you simply return the car and
don’t buy it.
Who Should Lease
People who tend to buy a new car every four years anyway.
Whatever your reasons, if you like to drive a spiffy new car,
leasing can be a smart way to avoid the hassles of reselling.
People who don’t get around much. Like the rental car you
get at the airport, most leases cover you for a certain number
of miles. Anything above that you pay for mile by mile, and at
a rather high price. Be realistic. If you think that you’ll drive
beyond the “free” miles, leasing will end up being an expensive
choice.
Leasing vs. Buying: An Example
Amy and Carlos don’t know each other, but on the same day in
June they both drive away in identical $20,000 Hoyota Hamsters.
Amy’s a real estate agent, and she feels a shiny new car will
impress clients as she chauffeurs them about. But since her
gleaming Hamster won’t be quite so impressive some years from
now, she opts to lease. That way she’s not paying for the car,
she’s paying for the right to experience a new car…perpetually.
Carlos is a designer, an artistic soul who thinks making his socks
match is enough of a concession to conformity. He didn’t want
to buy a new car: he was perfectly happy with his ’59 Nash, but
it’s darn hard to get parts for it nowadays. He likes the looks and
durability of the Hamster, so he opts to buy.
Amy plunks down $1,000 on signing to cover the security
deposit, various fees and the immediate depreciation—yes, the
car’s value declines as soon as she gets out of the lot. Ouch!
Carlos pays $4,000 down (the maximum he can afford) to
decrease his monthly payments. That means Carlos is committing
to payments of $550 a month, while Amy is paying only $375.
Time passes. Amy carts her clients around, and Carlos commutes.
With the money she saves, Amy eats out several times a week
and vacations in Maui. Carlos becomes highly skilled at cooking
pasta and vacations in front of his VCR.
Both are careful drivers, avoiding any mishaps to the cars
themselves. Amy is careful to keep her car in good shape
(to avoid fines upon returning the car), and shuns any
customization—even bumper stickers are avoided. On the other
hand, Carlos gives his creativity free reign: he opts for orange
pinstriping, a sunset airbrushed on the driver’s side door and a
custom surfboard-holder installed on top.
At the end of three years, Amy gives her car back. She’s paid a
total of $14,500, and she’s got nothing to show for it except a
decent number of satisfied clients, and another lease (this time on
a Cadillac). The only hitch is that she exceeded the mileage limit
by 2,000 miles, and has to kick down 15 cents a mile.
Carlos steers clear of the car dealer. He now owns his car
outright, and could probably get $10,000 for it if he sold it to
someone else who likes sunsets. But he plans to drive it for
another ten years or so, until it begins to fall apart. By then,
who knows? Maybe he’ll have learned to overhaul the engine
himself. It might be a little scruffy, but it’s still a monument to his
personal expression. And now it’s his turn to take that surfboard
to Maui—because now he’s $550 richer every month.
Who wins? It depends on your perspective. Amy pays a lot of
money, but she always has a shiny new car. Her payments are
always low, but they are endless. On the other hand, Carlos’s
budget was squeezed for three years but now he’s in the clear.
Which sounds better to you?