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Should you lease or buy your next car?

We look at the eternal question: Is it better to lease or buy your next car?

Before we tackle this age-old question, let’s set the stage.

Take the example of a car with a sticker price of $34,000. To buy it, with a 7% four-year loan and a down payment of 20% ($6,800), your payment would be $650 a month.

However, if you were to lease instead, you would pay a one-month refundable security deposit and your payment would be $450 a month.

Thus, leasing would save you $200 a month, and you would need only $450 down, not $6,800 (plus, in both cases, sales tax). This is why leasing is so popular.

And why the eternal question of “should I lease or buy a car” is not such a simple one to answer.

Why lease payments are so cheap

Economically speaking, cars consist of three parts: equity (ownership), depreciation (loss in value over time) and interest expense (on the loan, if any). If you finance the purchase of a car, you pay for all three parts, and you will own the vehicle in, say, four years. But if you lease, you are paying only for use of the vehicle.

Therefore, you pay for the car’s depreciation and interest, not the equity, and you return the car at the end of the lease term. This is why monthly lease payments are lower than purchase payments. Leasing, quite simply, is the difference between owning a car and renting one.

Why would a car dealer want you to rent (i.e., lease)? It’s simple: If you lease the car, you pay $450 a month for four years. Then you give the car back, giving the dealer the chance to resell it. In other words, the dealer gets to sell the same car twice!

This means the dealer doesn’t have to charge you (the first buyer) the full $34,000; you pay only the difference between what the car is worth today ($34,000) and what it will be worth four years from now. The second buyer pays the rest at that time.

Say the dealer expects this $34,000 car to be worth $15,200 in four years. He would, therefore, want you to pay $18,800 and the second buyer to pay $15,200. Thus, your lease payments would be based on just $18,800, whereas your payments to buy would be based on the full $34,000. That’s why your monthly lease payments are $450 instead of $650. When the dealer resells the car in four years, he’ll get the other $15,200.

The key factor: Residual value

Leasing, then, features lower monthly payments because dealers expect the car to retain a certain value. In reality, though, lease rates are not based on what the car’s residual value will be, but on what the dealer pretends it will be.

That’s why lease payments often are so attractive. If, according to industry standards, a $40,000 car will be worth only $12,000 in four years, the dealer would have to base your lease on $28,000 worth of depreciation.

That would make the lease payment absurdly high, and no one would take the deal. So the dealer pretends that the residual value will be $30,000, leading to lower, more attractive, lease payments. This game is dangerous for the dealer but a bargain for you.

The key to the cost of leasing, then, is the “residual value,” or what the dealer says the car will be worth at the end of the lease. Expensive cars tend to offer better lease deals than cheaper cars, for they retain more of their value, and the higher the residual value, the lower your lease payments.

3 money-saving tips when leasing

As with most financial transactions, success or failure is found in the fine print. Here are three items to keep in mind before you decide to lease your next car:

Money-saving tip #1: Make sure you have gap insurance

This is perhaps the single most important – and most overlooked – element of leasing.

Your contract might say the car’s residual value at the end of the lease will be $15,200, but the car’s actual value will be only $10,000. If you wreck the car three months before your lease expires, guess how much your insurance company will pay in settlement?

The insurer will pay the dealer (who owns the car) the actual market value, which is $10,000. But your contract says the residual value is $15,200. That means you are responsible for the other $5,200.

This “gap” between the lease contract’s stated residual value and the car’s actual value has caused many lessees to incur huge losses due to accidents.

The solution: Make sure your lease contract includes “gap insurance” – even if you have to pay extra for it, for being without it is like driving without insurance.

Money-saving tip #2: Avoid the cap cost reduction

When someone buys a car, the more money they put down, the less their monthly payments. Similarly, to lower your lease payments, you can make a cap cost reduction, which is a large, one-time payment made at the start of the lease. And as with a down payment, the more you pay in cap (short for capitalized) cost reductions, the lower your monthly payments. However, this is where the similarity ends.

Remember that when leasing, you do not own the car. Thus, if you make a cap cost reduction, you are making a down payment on property that is not yours. Never do that – no matter how much the dealer wants you to, and no matter how much it reduces your monthly payments – for in the long run, you are throwing your money away.

And the run might not be so long, either: Steve leased a $25,000 car and paid $3,000 in cap costs. Two months later, he totaled the car. Since he didn’t own the car, his insurer repaid the dealer $22,000; Steve lost his $3,000.

Paying cap costs is a waste even if you don’t wreck the car. Why? Because the only reason dealers want you to pay it is so they can offer you a monthly payment that sounds really low.

Would you visit a dealer who advertised a $20,000 car for just $199 a month? You bet! But would you get excited about having to pay $263 per month for the same car? Not likely. And that’s why dealers want you to pay a cap cost reduction.

Take, for example, a car dealer offering a $20,000 car for $199 per month for 24 months with a cap cost reduction of $1,525. But paying $199 per month with $1,525 down is the same as paying $263 per month with no cap cost reduction. If $263 doesn’t sound so hot (and it’s not), then the other deal isn’t so hot, either.

Instead of paying a cap cost reduction to lower your payments, ask the dealer to let you make additional security deposits. This will have the same effect as a cap cost reduction, except you’ll get the deposit back when you return the car.

Money-saving tip #3: Never buy optional equipment in a car you’re not buying

When leasing a car, you must keep in mind that you don’t own the car. That means you must be careful when agreeing to options that the dealer offers you.

Let’s say you worked out a fine deal to lease your next car – $250 per month for 36 months, with no cap cost reduction.

But then you decide to have the dealer install mats, fancier rims, an iPhone adapter and a navigation system. The cost of all these items came to $1,800, so the dealer added $50 to the monthly payment.

On the surface you might think this is a great deal because you are paying for the options over three years and the dealer did not add in any interest.

But when the lease expires three years later and you return the car, the mats, rims, iPhone adapter and navigation system go with it. That means you paid the full cost of owning those items, but only rented them for three years.

A better strategy would be to incorporate the cost of the options into the overall price of the car and then negotiate the lease price. That way, you’re paying rent on the options only for the time you drive the car.

Remember: When you lease, you are renting the car and everything in it. Don’t pay the costs of ownership when you lease.

Leasing and taxes

When leasing, you are liable for sales tax even though you do not own the car. If your state levies a personal property tax, you’ll have to pay this, too. But to entice you to lease, many dealers offer to pay the property tax for you. Shop around for the best deal as you decide whether to lease or buy your next car.

Don’t lease beyond the car’s warranty

If you choose to lease, don’t lease for a term beyond the car’s warranty. If the car comes with a two-year bumper-to-bumper warranty, for example, get a two-year lease. By opting for a three-year lease, you could be stuck with huge repair bills in year three – on a car you don’t own!

Leasing for business

Leasing makes great sense for business, regardless of how many miles you drive, because you are allowed to deduct the cost as a business expense. (If you buy a car for business, you must depreciate it instead.) These can add up to be sizable tax benefits because you can also deduct the associated costs with leasing a car, such as maintenance, gas or mileage, insurance and registration fees.

To lease or buy, that is the question: Here is the answer

To determine whether you should lease or buy your next car, answer these two simple questions:

  1. How many miles do you drive per year?

In most leases, you are allowed to drive only 10,000 to 15,000 miles per year, 40,000 to 60,000 miles on a four-year lease. Anything more will cost you up to 25 cents per mile.

As a result, unless you are among the relatively small number of people who drive fewer than 10,000 miles a year, it will be cheaper for you to negotiate a more expensive lease with a higher mileage limit than for you to pay 25 cents for every mile over the limit you drive.

If you know you’ll drive significantly fewer miles than 10,000 to 15,000 per year, you can negotiate a lower lease payment.

  1. How long do you generally keep your car?

Leasing is best for people who keep their cars for four years or less. Remember that when leasing, you never enjoy a payment-free month. At the end of the lease, you must turn in the car and get a new one, with a new lease or purchase contract.

Thus, if you like to keep cars for seven or eight years, you’ll find that, over the long run, leasing is much more expensive than buying.

Since cars are one of the largest purchases you’ll make, talk with your financial advisor before you decide whether to lease or buy your next car, how much to put down and whether you should finance. The right decision can save you thousands! The experienced professionals at Edelman Financial Engines can assist with answering your financial or other wealth management questions.

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