Leasing versus Buying That New Car
To Buy or Not To Buy, That Is the Question
With all the advertisements for snazzy new cars and low monthly payments, it is becoming increasingly difficult to resist the siren call beckoning us to our local dealership. Without exploring the compulsions that underlie the American need for constant renewal, it is nonetheless apparent that we are a society that likes to drive newer cars. The average American trades cars every three to four years. Now that competition among manufacturers has intensified, many are offering a new enticement: the short-term lease.
Since many Americans grew up with their parents telling them to “buy when you can pay for it” and “a car is an asset,” it is hard to understand why leasing, which involves monthly payments for something you do not own, has caught on. The answer is twofold. For many drivers, leasing allows them to drive a nicer car than they may otherwise be able to afford. Plus, in some cases, it just makes good economic sense.
Most of us finance our triennial trades with a loan, contrary to Dad's advice, which means we're already in the habit of making monthly payments. To keep those payments as low as possible, we tend to take out a five-year loan to pay for our new purchases. The result? At the end of the five-year period we may well own the car, but chances are we really wanted to trade it in a year ago. One other point: our parents neglected to tell us that a car is a depreciating asset, that is, it loses value over time with some makes and models depreciating faster than others. So, the car we now own and don't really want isn't worth very much when we try to trade it in.
To Lease, Perchance To Dream . . .
The leasing alternative addresses all these desires. Because the term of the average lease is shorter than that of the average loan, it allows us to move onto the next car more quickly, and payments tend to be more affordable than loan payments. Let's look at a concrete example.
A 1997 Honda Accord retails for about $19,500, but you could probably haggle the price down to $18,500. The average interest rate on a five-year loan for a new car is approximately 8.9%, and the monthly payments will be $345 if we pay 10% of the purchase price up front. As soon as we drive the car off the lot, it becomes a used car whose value is significantly lower than the amount we have just agreed to pay back over the next sixty months. The payments made in the early part of the loan mostly cover the interest, while those in the later stages cover more principal, so it takes some time for the value we could get for the car as a trade-in to be the same as the amount we have left to pay on the loan.
If we choose to lease this car instead, we would pay $259 per month for 36 months, and at the end of that time we would have three options. First, we could buy the car at a wholesale price determined when we signed the lease and guaranteed by the terms of the lease, in this case about $13,054. Second, we could trade it in to the dealer at a (higher) average trade-in price and buy or lease another car, trade-in value being about $14,200. Third, we could decide to buy the car at the wholesale price then sell it privately (without a dealer) at a presumably still higher price, about $15,900. We could also simply choose to conclude our payments and then walk away (literally, since we would not have traded the car for a newer one or bought the one we had been leasing).
It is important to understand that the cost of the lease is really the difference in the purchase price at signing and the purchase price available to you at the end of the lease, plus some finance charges, divided by the number of months in the lease. Here's why this matters: if you plan to buy the car at the end of the lease, you want the buyout price to be as low as possible, so that when you buy it you have a lower purchase price. If, however, you plan to just lease another car, you want the buyout price to be as high as possible because the cost of the lease (i.e., the difference between the purchase prices at the beginning and end of the lease) will be smaller. Also, cars that retain their value will be cheaper to lease for the same reason: there is less depreciation between the initial value and the residual value.
Apart from the obvious benefit of leasing (instant gratification of an affordable new car every three years), leasing also offers some unique benefits that purchasing does not. For example, leasing allows you to pay for the sales tax over the period of the lease, rather than all at once when you register the car, as is required in some states when you buy a car. Leasing also provides added insurance against unexpected losses. Let's say that you drive a new car off the lot and get hit by a Mack truck, totaling the car. You consider yourself lucky to have survived the accident until you realize that you still owe the bank the full amount of the loan, but that the insurance company is going to treat the value of the car as its replacement value, which would be that for a used car. You would need to pay out of pocket the difference between the amount of the insurance check (for a depreciated used car) and the amount of the loan. If you had leased the car, the bank fee you would have paid goes to purchase “gap insurance,” which guarantees that the leasing company will absorb any deficiency between the insurance reimbursement for a totaled or stolen car and the remaining payments on the lease.
To Buy—Aye, There's the Rub
But buying has its benefits, too. First, if you drive more than 15,000 miles per year, a lease can become quite costly. The lease agreement generally provides an allowance of 12,000 miles per year, and you must pay for every mile above the allotment, usually $0.15 per mile. If you know up-front that you will put on more than the allotted miles, you may choose to pay for the projected excess miles ahead of time, usually at a reduced rate ($0.08 to $0.10 per mile). Also, if you tend to keep cars for more than five years, or are able to finance for shorter periods (if at all), then buying a car may be cheaper than leasing. Ultimately, you will need to balance your desire to drive a newer car with your tolerance for monthly payments to determine whether leasing is right for you. Here are a few points to keep in mind as you weigh your decision:
Whether you lease or buy, it is always better, economically speaking, to choose a car that retains its value over time. If you need to trade it in early, you are more likely to get back at least what you owe.—TMV
Information Please® Database, © 2007 Pearson Education, Inc. All rights reserved.