In this post, I’ll discuss leasing vs buying a car, the benefits and the downsides of both, and I’ll teach you how to calculate a car lease payment.
The car is the most expensive purchase most people make that goes down in value.
What if you didn’t actually buy the car at all? Would that be better for your financial future?
That’s what we’re going to be talking about, leasing vs buying a car.
We’ll discuss the following:
What leasing a car is and how it differs from buying a car?
Some of the benefits and downsides of both Leasing and buying a car
I’ll show you how to calculate a car lease payment.
Then I’ll do a bit of a mathematical comparison between the two options where I will also tell you how Financial personalities like Dave Ramsey say that Car leases charge you an effective interest rate of about 14 or 15%
The difference between leasing and buying a car
So first, let’s define the difference between Leasing and buying a car:
The best way that I can explain it is that leasing a car is basically just renting the car
Similar to how you might decide to rent an apartment instead of buying a house.
Now, when you lease a car the lease or the person that holds the lease rents the car to you, the lessee, for a specified period of time in return for periodic payments
Now that sounds, in many ways, very similar to what happens when you sign a car loan right?
The difference of course is that once you finish paying off the car loan you own the car. However when you lease a car and the lease term ends you give the car back, assuming you sign another lease you end up getting a new car.
This means that at no point in time do you actually own the car; it is never an asset for you opposite to if you were to sign a car loan and make the payments.
In this case, after making the final payment, the car would be an asset to you.
Of course, you can decide to purchase the car that you lease at the end of the lease,
That is an option but not a whole lot of people do that.
The benefits of leasing a vehicle
The first benefit that people often point to is that under most circumstances unless of course, you make a really big down payment when you buy a car the monthly payment on a lease is generally lower than the monthly payment on a car loan. (I’ll show you why that is when we get to the example)
Second, there’s no need to worry about selling your car at the end of the lease
Because when the lease term ends, as I said you simply drop the car off at the dealership
Third, the car oftentimes remains covered under a warranty because the lease terms generally don’t last more than say about 3 years and sometimes they’re even shorter and since the warranty on most cars is roughly the same as the lease length you oftentimes have a more predictable total cost of car ownership.
And some leases may even include things like basic maintenance
So if that’s the case your only costs would be insurance and fuel.
Fourth, a lease requires a small down payment.
Sometimes nothing at all, and you can argue whether or not that’s really a benefit
But for those who don’t have money saved up for a down payment, it seems like a really good benefit
And obviously, once you’re leasing a car every few years you always have access to the latest technology
Because your car is always relatively new and for many, this is a huge benefit
The last benefit is the potential tax savings that you may experience.
Although you definitely want to check with a tax professional to find out exactly how leased vehicles are taxed in your area because it does vary from place to place.
The downsides of leasing a car
First, all the rules and restrictions that seem to pop up all over the place. Depending on the lease, you may have mileage restrictions, excess wear-and-tear fees, ride-sharing restrictions, the need to have excellent credit in order to lease the car in the first place, ..Etc.
Typically you will have mileage restrictions on most leases between 9,000 and 15,000 miles per year
And if you go over that you can get charged an excess mileage fee. Which can range anywhere from $0.20/mile to $0.25/mile.
Now, of course, people who lease you a car don’t generally check the number of miles you drive each and every year
But rather say if it’s a three-year lease and you’re allowed to drive 15000 miles per year, they’ll end up checking it at the end of the lease and see if you went over 45,000 miles.
As far as the excess wear-and-tear fees go, I’m told to expect some wear-and-tear and you won’t be charged for every minute thing
But the car needs to be nearly in its original condition when you return it
And any customization that you put on the car needs to be easily removable.
And in some places, you’ll also have to be able to show that you performed all the recommended services at the proper times.
So I imagine there’s quite a bit more paperwork that can go with this option as opposed to buying a car. This, for some, may matter but for others, it may be worth it with the benefits.
I’ve also been told that with very few exceptions you need to have top-notch credit score to be able to lease a car.
And the last downside to leasing a car is that:
Some leases will have early trading fees or penalties
And you never hold any equity in the vehicle when you return it at the end of the lease contract
Meaning you’ll never be able to get any money back to use for a down payment on your next vehicle.
The benefits of buying a car
When you buy a car you don’t have any monthly payments after the loan is paid off. You don’t have any mileage or customization restrictions, excess wear-and-tear fees, and your credit does not have to be excellent although it would certainly help when it comes to interest rates on loans
The downsides of buying a car
However, it is generally more expensive in the short-term, month-to-month than leasing is.
And some dealers will try to talk you into a long-term loan since it makes the monthly payment look a lot smaller but it usually has a higher interest rate and it keeps you in debt longer which isn’t a good thing.
Also, the down payment is oftentimes much larger when you buy a car then it is when you lease it.
So with that out of the way, how do you calculate a monthly lease payment?
You’ll need a few things:
- The MSRP of the vehicle (the sticker price of the car).
- The money factor. This is also sometimes called the lease factor or even the lease fee and you usually need to call the dealership that you’re looking to lease the car from in order to get this. They will likely ask you what kind of car and model you’re considering to lease? So be sure to have that information ready when you call.
- The lease term or length. Most of the places that I researched recommended leasing for no more than 36 months
- once you have that, you want to find the residual value of the car by asking the dealer what the residual percentage is for the specific car that you’re considering while you’re on the phone with them.
The residual percentage varies of course between dealers but it’s somewhere in the neighborhood of 45% to 60% for a 36 month lease on average
- Find out if there are any fees associated with the lease. Common fees include registration fees, acquisition fees, and sometimes down payment tax but there may be others.
- Find out if there are any rebates that are available to you.
Once you have all that information here’s how you calculate your monthly lease payment:
for this example let’s say that John is going to be leasing a car with:
An MSRP of $25,000
The residual percentage is 50%
And the money factor or the lease factor will be 0.00125
He’s Leasing, and will not make any down payments on the car.
He does not have any rebates but he does have $1,200 in various fees
The lease term is 36 months.
Once he has all this information here is how he starts to calculate his lease payment:
Step 1: MSRP * Residual % = Residual Value
$25,000 * 50% = $12,500
Step 2: MSRP + Fees = Gross Capitalized Cost
$25,000 + $1,200 = $26,200
Step 3: Down Payment + Trade in Equity + Rebates = CAP Cost Reduction
To simplify things in our example John didn’t make any down payments. He didn’t have any trade-in equity or rebates so his CAP Cost Reduction = $0
Step 4: Gross Capitalized Cost – Capitalized Cost Reduction = Adjusted Capitalized Cost
$26,200 – $0 = $26,200
Step 5: Adjusted Capitalized Cost – Residual value = Depreciation Amount
$26,200 – $12,500 = $13,700
(This number is very important because it’s what your base monthly lease payment is going to be calculated with)
Step 6: Depreciation Amount / Lease Term (Months) = Base Lease Payment
$13,700 / 36 = $380.56/MO
Step 7: (Adjusted Capitalized Cost + Residual Value) * Money Factor = Rent Charge
($26,200 + $12,500) * 0.00125 = $48.38/MO
Step 8: Rent Charge + Base lease Payment = Pre-Tax Lease Payment
$380.56/MO + $48.38/MO = $428.94/MO
Now, if you’re lucky and live in a state that doesn’t charge sales tax than you’re done calculating your lease payment.
However, if you’re like most of us you’ll have to add the sales tax
Step 9: Pre-Tax Lease Payment * Local Tax Rate = Monthly Lease Payment
Let’s say that John in Santa Monica C.A. they have a sales tax of about 9.5%
$428.94 * 1.095 = $469.69
That was a lot! Yes, lease payments are complicated but that’s how you calculate them.
Effective interest rates of Leases
Now, I know that you’ve probably heard that leasing a car is the most expensive way to own a car because on average the effective interest rate on car leases are about 14% to 15%
This is about as high as the average interest on credit cards.
So it’s kind of a big deal but one thing that I’ve never heard being talked about before is how people are calculating that effective interest rate to arrive to such high percentage
Because you certainly didn’t see on the lease contract anything that says “Hey! You’re paying 15% interest on this, good luck”
You see what the money factor is of course but that’s about it.
Well, here’s how you calculate it:
When John was paying for that lease on a $25,000 car his Base Monthly Payments weren’t actually being calculated on $25,000, they were being calculated based on the difference between the cost of the car and what the residual value of the car will be at the end of the lease term
This is obviously estimated by the leasing company prior to you signing the lease
In this example, the difference between those two numbers was his Depreciation Amount of $13,700
So let’s say that instead of leasing the car he decided to buy a car for the same $13,700 that his base monthly lease payments were being calculated with and let’s also say that the $13,700 car loan that he signed when he bought the car was for 36 months and his monthly payment was just $469.69
Just like they ended up being for his lease
If you punch those numbers into a loan calculator and ask it to find out what the interest rate on the loan was you’ll see that it comes out to be about 14.2%
To add to this, do you want to know how much you’d be paying a month if you bought a $25,000 car instead of leasing it?
Well, assuming we go with the average interest rate on a car loan is a little under 4.5%, so we’ll use that
And let’s say it’s a 60-month car loan
The monthly payment is $466.08 which is not all that much different than the lease
Except for the fact that you may have some resale value at the end of the cars run that you can then use for a down payment on the next one
The conclusion to Leasing vs Buying a car
So as you can probably tell I’m in favor of buying cars as opposed to leasing them but that doesn’t mean that my opinion is objectively and universally the correct one, everyone’s situation is different.
For some people, it may be worth taking on that higher effective interest rate in order to always be driving with the latest technology and not have to go through the hassle of selling the car at the end of its run and that’s perfectly fine.
My goal with this post was never to tell you what to do with your money. My goal is just to make sure you’re aware of what options are out there and do my best to clear up any mysteries in the realm of personal finance so that you know where your money is going to and why it’s going there.
Thanks for your time
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