The leasing transaction is very different from purchasing a car with a traditional auto loan. When you lease a car, typically the car dealership sells the car to a lease financing company, who in turn leases the car to you. So, you don’t actually lease the car from the dealership (although it is often the car manufacturer’s own financing subsidiary that purchases the car from the dealership). When you lease a car, a typical transaction works something like this:
- Sells the car to the financing company
- Receives revenues from the sale of the car and any associated profit, after paying the manufacturer for the car
- Receives revenues from you to recoup any costs associated with selling the car (e.g. “dealer handling fees”)
- Receives “commission” revenues from a portion of the financing offered by the lease financing company (assuming you use the dealer’s financing options and do not use an independent financing company)
Lease Financing Company:
- Owns the car
- Leases the car to you
- Receives “interest” from you
- Sells the car (they hope at a profit) at the end of the lease to you, the dealer, or another party
Where leasing is relatively attractive vs. purchasing:
- You get to drive a new car more frequently, which may be good for people who would buy a new car every 3-5 years anyway. (This is usually more of a lifestyle choice, not a financial decision.)
- There are lower upfront costs and lower monthly payments (i.e. you get more car with the same monthly payment than you could vs. purchasing).
- There are less taxes associated with leasing. In most states, you pay tax only on the lease amount while the car is in your possession, instead of upfront on the total amount on a purchased car.
- There are limited or no maintenance costs. Typical leases are 3 years which is usually the duration of the manufacturer’s bumper to bumper warranty.
- If you own your own business and use your car for work purposes, you may be able to deduct your lease payments. (You can do this for a purchased car as well, but the tax treatment is more favorable on a leased car.)
- Leasing becomes relatively more attractive at a high nominal interest rate because you typically have to borrow more to purchase a car.
- If you can successfully negotiate great terms (get a great purchase price, low money factor, very high residual value), you can purchase the car at the end of the term at cheaper than fair market price.
- Traditional purchase loans amortize (i.e. higher percentage of your monthly payments goes to interest), so if you purchased a car that depreciates very fast with an amortizing loan, you could possibly get “upside down” on the car (you owe more on the loan than the car is worth). With a lease, you cannot get “upside down.”
- With a lease, you have the “optionality” of purchasing the car (at the agreed upon residual value, adjusted for any fees when you turn it in).
Where leasing is disadvantageous vs. purchasing:
- There is no equity building (you have no ownership of the car).
- There are punitive penalty costs -- i.e. mileage limits and overages ($0.05 - $0.20 / mile), costs for excessive wear and tear.
- There is an extra expense for “gap insurance” to pay off remaining lease amount in the event the car is totaled.
- Recurring transactions costs must be factored in -- most buyers don’t sell after three years and there are higher initial insurance costs on newer cars plus gap insurance.
- A lease is a contract, a liability with defined terms, so there are actually more financial and legal commitments than if you purchased a car with a traditional loan
- Lessees may be more sensitive to credit ratings (low or no upfront outlays can mean more credit risk, which makes it harder to get a lease than to purchase).
- There are limitations on vehicle customization.
- Leasing is a more difficult and complex transaction to understand, which makes it harder for a typical consumer to determine if they are getting a fair deal.
From a financial perspective, there are certain things to consider when evaluating the buy vs. lease decision:
Here is what you pay for when you buy a car:
- Owning the car (“equity building”)
- Depreciation – for the entire time you own the car
- Sales tax on the total car
- Interest costs on the auto loan
- Opportunity cost of lost income on your cash down payment and additional monthly car payments (income you could have received had you not committed it purchasing a car)
Here's what you pay for when you lease a car:
- Depreciation – for the duration of the lease term
- Interest costs (the costs of tying up the financing company’s capital)
- Risk of wrecking the car (gap insurance)
- Sales tax on the lease payments
- You do not pay to “own” the car
All things equal, the longer you own a purchased vehicle, the more attractive it is to buy (vs. lease). Vehicles that hold their value longer (i.e. depreciate less) are cheaper to lease (and more expense to purchase when the lease expires).
Be wary of taking a lease term longer than the manufacturer’s bumper to bumper warranty
With a lease, the interest (money factor) and depreciation is divided equally over the lease period vs. a loan, which is amortizing (higher interest component at the beginning of the loan term)
When you negotiate a lease:
- DO NOT negotiate on monthly payment (this is usually the first question: “how much do you want to pay a month?”)
- DO negotiate on:
- Purchase Price -- Lower is better
- Money Factor -- Implied interest rate, (lower is better) do your homework know what the money factor is, watch out for dealer mark ups on the Money Factor
- Residual Percentage or Residual Value (higher is better), what is the leased/purchased car worth at the lease period/when you sell the car (note: that a higher residual value will make the monthly payments cheaper, but will increase the cost of the car if you choose to purchase it at the end of the lease)
So, which is right for you? It depends. For most people the decision is really one of lifestyle. For those who like sporting a new car and don’t mind going through the process every few years, leasing is a reasonable option. Leasing may also make sense for the financially savvy and the diligent consumer who is willing to learn the complexities of the lease transaction. These are the people who see car shopping as a competitive sport. Broadly speaking, most people won’t incur the brain damage to completely understand the leasing transaction and/or don’t want to deal with the hassle of going through the process every a few years.
So how can you make the decision that is best for you based on cold, hard numbers? We have the formula, just plug in your own numbers. Check it out.
This post was written by E.K Evans, CFA. If you’d like to submit a guest post, email us at firstname.lastname@example.org.