Do you know the difference between a bookkeeper and an accountant? A bookkeeper puts numbers into Pastel or whatever accounting software they use. An accountant can tell you what those numbers actually mean, which is why everyone really needs an accountant in their lives. This also applies when figuring out whether it is better to lease or buy a car.
One time I saw how important their knowledge can be when I was visiting a small business owner in his office. He had recently decided to (finally) make use of the services of an external accountant, who happened to turn up at the same time and practically yelled at him:
Why did you buy all those trucks? Do you know how much you could have saved by leasing?
Table of Contents
- 1 Snakes and Ladders
- 2 Leasing a Car vs Buying a Car
- 3 What Are the Benefits and Downsides of Leasing a Car?
- 4 What Are the Benefits and Downsides of Buying a Car?
- 5 Is It Better to Lease, or Buy a Car on Credit: The Difference Between Lease and Finance
- 6 How to Find the Best Deals on Car Leases
- 7 The Verdict: Is Leasing a Car Better than Buying?
- 8 Should I Buy or Lease a Car to Save on Taxes?
- 9 A Final Word
Snakes and Ladders
This illustrates an important point: even apparently simple financial decisions sometimes come with strings attached. It’s worth doing a little research, even when “everyone does” something a certain way, or your smart uncle advised a particular course of action. The guy mentioned above had years of business experience and could certainly be called financially literate, yet he had never actually thought through the differences between leasing a car vs buying a car.
Leasing and buying are very similar in theory, so it’s no surprise that many people are confused about which will work better for them. Unless you can pay the full price in cash, both mean that someone entrusts you with a vehicle with the expectation that you will send them some money each month. If you don’t keep up with the payments, you lose the car, either through the bank or automaker enforcing a lien or the owner simply taking their car back.
When posing the question “Is leasing a car better than buying?” seriously, though, you’ll find some major discrepancies in practical terms. Let’s take a quick look at how both work before we delve a little deeper into the details.
Leasing a Car vs Buying a Car
Renting a car for a couple of days is fairly simple: you show the guy behind the counter some ID and a credit card and, unless you go stock car racing with it or manage to get it towed, you simply pay for the time and mileage you’ve used it. Leasing or buying a car is a far more important financial decision, so knowing at least the basics can save you a lot of money.
What Happens When I Buy a Car?
It’s possible that you have enough cash in your metaphorical back pocket to purchase a car outright; if so, good for you. If this is the case, buying a car is in principle no different from ordering a hamburger. Cash and goods exchange hands, and then all that’s left to do is fill out the forms and shake hands.
Most people, however, will take out a loan to finance their new wheels. This isn’t a bad idea: perhaps the extra interest you pay will be offset by the lower maintenance costs of a newer car, while interest rates are very low at the moment anyway.
The thing to understand is that, with a loan, you’re paying interest on the money you’ve borrowed; the actual car has little to do with anything. With almost all car loans, you pay a fixed amount each month and (hopefully) a down payment. The two graphs below illustrate why:
By paying $10,000 up front, not only are the payments much lower ($750 versus $940), you save $1,250 in interest payments over the life of the loan.
What Happens When I Lease a Car?
Leasing a car generally starts with searching for deals online or visiting a dealership. Once you’ve selected the car and negotiated a monthly rate, a leasing company (which is often a bank or a car manufacturing company) buys the car; they are now the owner, but you can use it. (Even though you don’t own the car, you have to register it in your name; General Motors doesn’t want to get your speeding tickets). You agree to give the vehicle back at the end of some period of time, usually 24 or 36 months. If your contract allows, you can also choose to buy it at that time. Simple, right?
Actually, no. Unlike a loan, the amount you pay “interest” is intrinsically linked to the physical car. To make that a little clearer, the major part of your lease payments are to compensate the bank for the car’s depreciation while it’s in your care.
Since I just love graphs, here’s another one.
Instead of the car’s market price, you pay a rate based on the difference between what the car is worth now (its “capitalized cost”) and its expected wholesale value at the end of the lease period, called the residual. In the above example, the lease is for 36 months and the car is expected to lose $14,000 in value, so
14000 / 36 = 389
and $389 is the starting point for the calculations the bank will do. To this figure are added any bank fees and the “money factor”, which plays the same role as interest does in a loan. When negotiating your lease, you also need to be aware of the following:
- Insurance and Maintenance: These may or may not be included. If they aren’t, they’re your responsibility: if you can’t hand over the car at the end of the lease, you have to pay full price for a stolen or totaled vehicle.
- Mileage Allowance: To make sure that their car doesn’t lose its value faster than they expect, the leasing company imposes a limit on the amount you can use the vehicle during the leasing period. Any additional mile driven over this cap costs you money, and not just for gas: a rate of 15-20c per mile is not unusual and can seriously dent your wallet if you’re not careful. On the other hand, a higher mileage allowance costs more in monthly payments, so estimating the distance you’ll actually need to travel each month is a very good idea.
- Down Payment: Offering to pay a lump sum on signing the contract shows the bank you’re serious. This will reduce both your monthly payments and the money factor charged by the leasing company.
- Other Charges: Many banks charge you a “disposal fee” at the end of the lease period to cover their costs in preparing the vehicle for the next driver, early termination charges (which can be substantial) and other fees which don’t always make much sense. Make sure you’re aware of all of these, or you risk getting a nasty surprise later.
- Purchase Option: You may or may not want the ability to buy the vehicle at the end of the lease term. If you’re sure you won’t want to purchase it, this clause doesn’t matter, but it can also be a key negotiating point. Specifically, if you’re reasonably sure you’ll want to buy, you will probably argue for a lower residual value, which is what you’ll end up paying for the car at the end of the lease. This increases your monthly payments as described above, though, so take some time to think about it.
What Are the Benefits and Downsides of Leasing a Car?
- Lower monthly payments than with a bank loan.
- You can probably get a much more expensive car, temporarily, than by buying one.
- On the other hand, if your goal is to pay as little as possible in the coming months, you’ll also find used compact and economy cars available to lease.
- The residual (i.e. trade-in value) and other numbers are fixed when you sign the lease, making your financial planning that much easier.
- With a lease swap, which basically means taking over the remaining time on another person’s lease, you can lease a car for only a few months without taking on any long-term commitment.
- Although there are big differences in the way car lease contracts are written and may include an option to buy, some of them are meant to be paid off fully only by returning the car to the dealer. You could spend thousands of dollars over the years and still not own so much as a spark plug at the end.
- Some leased cars are new…and some less so. Especially since you don’t know much about the motoring habits of the previous users, maintenance costs can end up being more than you thought. You’ll be responsible for these, as well as comprehensive insurance.
- Once you sign the contract, you’re locked into those terms and changing them will be expensive. If you find your mileage allowance to be insufficient, for instance, paying the penalties for exceeding it can be painful.
- Similarly, the leasing company’s fee structure is often confusing. To give on example, they may hit you with a fine of a couple of hundred dollars or more for ending the lease early.
- Finally, even though you might be willing to live with a few dents and dings on your own car, the leasing company has a less liberal policy. If you return the car in less than “reasonable” (by their definition) condition, they can force you to pay for tires, bodywork and whatever else they deem necessary. There will also be a fee if you don’t have proof of its complete service history.
What Are the Benefits and Downsides of Buying a Car?
- If you have some money saved up, making a large down payment can save you a lot of interest.
- Once the loan is paid off, you own the car free and clear.
- Even before then, the car is yours to do with as you please. You’re not allowed to decorate or modify a leased car in any permanent way, nor (obviously) sell it.
- There’s no restriction on how far you may drive the car. If, for example, you take a job with a longer commute halfway through a 36-month lease, this will be a major advantage
- If you’re picky about exactly what you want from a car – and considering the safety, financial and practical implications, you probably should be – you can spend anything from weeks to months between deciding to buy one and actually signing a deal. This is totally appropriate for an important and complex decision but isn’t very convenient when you need a car immediately.
- Leasing companies actually go to some trouble to deliver only genuinely roadworthy cars. Private sellers and dealers will sometimes actually hide problems they know about. This isn’t uncommon, and you may end up paying far too much for the Lemon of the Century.
- On the flipside of this, selling a secondhand car often takes more time and effort than you’d think – unless you’re willing to take a loss on it. Returning a leased car is comparatively simple.
Is It Better to Lease, or Buy a Car on Credit: The Difference Between Lease and Finance
It seems appropriate to sum up all of the above in just a few sentences: what is the real difference between leasing and buying a vehicle?
Basically, at least in some senses, leasing gives you more flexibility. You’re more likely to find the exact car you want quickly, contracts can be negotiated to best suit your lifestyle (an elderly person might just need a runabout for going to the store; a businessman might want a flashy late-model sedan without paying the earth for it, etc.) and you can even trade the lease if circumstances require.
Taking out a car loan and buying means more responsibility, but also more control. If you stop making payments, the bank will tow your car and sell it at auction. Often, it doesn’t even sell for a fair market price, meaning that you might be out a car as well as any money you’ve already given the bank, and still owe them money.
On the other hand, you can sell it at will, drive it as much as you want; paint it purple if you like. When you own a vehicle, it’s up to you to maintain it poorly or to a higher standard than any leasing company requires. After you’ve paid off the loan, you will finally own it outright and be free even of the few restrictions the bank may have imposed on you, for example having comprehensive car insurance.
How to Find the Best Deals on Car Leases
Even now that you know the basic differences between leasing and buying, you still have some research to do. Actually going through the process requires some patience, a little negotiation skill and finding out as much about the market as you can.
Is It Cheaper to Lease or Buy a Car At a Dealership?
Physically visiting a dealer is the traditional way to initiate a car lease and it does have some advantages. Talking to someone face to face is a lot more comfortable, and a good customer service agent will often give expert advice for free. There is a caveat to this route, though: they are professionals at trading cars, while anyone reading this article is probably an amateur. Most of them won’t actually rip you off, but their negotiation skills and industry knowledge will be miles ahead of yours.
Here are some things to keep in mind:
- Many dealerships charge you an “Acquisition Fee” just for helping you fill out some forms – they actually ask for money to acquire you as a customer. Online lease marketplaces do the same, but are usually upfront about it; dealers sometimes wait until the ink on the contract is nearly dry before mentioning little ($500 or so) details like this.
- It never hurts to ask, nor to shop around. Usually, a dealership will have some headroom in their base price, as well as a couple of cars on the floor which they’re struggling to get rid of. Negotiate a little, but be polite: you can’t out-bluster the typical salesman.
- Do your research. For example, if you can find the Blue Book value of the same model car as the one you want to lease, but one three years older, you’ll know approximately what the residual value of yours should be.
- Negotiate the sale price first. The salesman and dealership owner cares a great deal about this, which is how they make most of their money. If, after you’ve come to an agreement in principle, you ask about leasing the car instead, this is just icing on the cake for them and they’ll be more amenable to meeting you halfway. There‘s certainly some wiggle room in terms of things like mileage limits and the residual value.
Taking Advantage of Lease Swaps
Lease swaps have many of the same disadvantages as buying a used car: when the lease is over, you will be liable for the previous driver running up the mileage or skimping on maintenance. At a minimum, you should visit AutoCheck to see if the car has been in an accident during the current lease period.
Despite these risks, looking at lease swaps can save you a lot of money. Here are some of the benefits:
- Huge Variety: There are dozens of websites that specialize in matching “sellers” to “buyers”. You can use these to search by region, car type, or whatever you choose. You can also keep an ear open around friends and family, or try general-purpose ad sites like CraigsList.
- Great Deals: While people want to get out of leases for a variety of reasons, it’s most commonly because they’ve hit a sticky spot and can’t afford the monthly payments. Rather than taking out a personal loan at high interest, they’d prefer just getting rid of the lease and car as soon as possible, meaning they’re happy to offer sweeteners, especially if the car already has a mileage close to the leasing company’s allowance. In other words, they’ll actually pay you money to take the lease off their hands:
- Shorter Leases: Banks don’t typically offer lease periods under 12 months; considering their administration costs, this just isn’t profitable for them. However, since you’re taking over an existing lease, they don’t really care if the end date is closer than that as long as someone continues to make the payments.
So, while some people will still prefer to work with a dependable dealership, especially one that’s helped them before, taking over someone else’s lease is often the best option. Just be aware that making the switch can cost up to several hundred dollars in total.
The Verdict: Is Leasing a Car Better than Buying?
Firstly, let’s say again that, when asking “Should I buy or lease a car?” the best option for someone else isn’t necessarily one that will work for you. This makes taking uninformed advice a dangerous thing to do. Still, while you’ll have to do your own homework on this, here are some typical situations in which either leasing or selling will probably be your best choice:
Strapped for Cash: Lease
If you absolutely have to have your own transport but your credit is low or you’re not earning a consistent sum of money every month, it will probably be much easier to be approved for (and keep up the payments on) a lease. This isn’t necessarily the case, though: you may still be approved for a loan on a car that has guaranteed resale value. Check out more than one option.
Mr. Moneypants: Buy
If you’re lucky enough to be able to afford a car in a lump sum without straining your financial position (meaning that you’ll still have a year’s living expenses in the bank or short-term investments), you can certainly do so. Taking out a five-year loan to finance 100% of a $50,000 car can easily cost you $6,000 or more in interest, which cash-rich people may think of as a kind of discount they’re getting compared to other people.
In addition to how much normal interest payments will cost you over the long run, many finance packages include a final “balloon” payment that’s much larger than the sum you normally send them each month. Unless, at the time, you can afford it easily, car dealerships can and will use this to pressure you into refinancing the existing loan or trading in your car for a new one – sold by them, of course.
The Serial Seller: Lease
If you want to drive a new or at least different car each year, you’re almost certainly better off leasing. Is it cheaper to lease or buy a car for the short term? Well, to answer that one, how many people you know would buy one for a week-long holiday?
A new vehicle loses approximately 20% of its value the moment you sign the purchase agreement. Not only does a shiny-fresh car have a unique emotional appeal, but most people will also assume there’s something wrong with it if you want to re-sell it the very next day.
For simplicity’s sake and because this is a common tax accounting convention, we can say that a car keeps losing a fifth of the original sale price every year after the first until it’s (theoretically) worth nothing. Of course, somebody will still be willing to give you money for it, but you might not like the offers.
In general, car ownership is for people who intend to drive it for at least a couple of years, and selling while still paying off the loan might cost you. One exception to this is people who insist on buying a new car every few years and are well-off enough to cover the outstanding loan amount as well as a new down payment, possibly by trading in their old car as part of the bargain.
Should I Buy or Lease a Car to Save on Taxes?
Author Robert Kiyosaki, although some of his advice is questionable, did articulate one principle I wholeheartedly agree with. This isn’t a direct quotation, but in any case:
Never choose a financial path based on a tax break. If the government offers you a discount for doing something, that means it’s for their benefit and not necessarily in your interest.
This obviously doesn’t imply that you shouldn’t try to pay less in taxes. Consulting an accountant just once a year can potentially save you quite a handy sum. What the above means is simply this: tax implications are only one of many aspects you should consider when thinking about any kind of transaction.
This does indeed require a lot of thinking. Some states, for example, tax lease swaps as if they were vehicle sales, even if no actual money changes hands between the two parties. The most important thing to consider here, unless you live in one the four states that don’t charge sales tax (Delaware also charges no sales tax, but does make you pay 4.25% of a bought vehicle’s value) is whether they assess a leased vehicle at full value, or only on its depreciation during the lease period. At the same time, you may be able to get a federal SALT deduction for whatever amount you pay the state, which makes sense if you have a high taxable income. Additional deductions, like 58 cents per mile traveled, can be claimed if you use the car for your own business.
That applies to both leased and owned vehicles, though. For the most part, while you should certainly ask whoever you’re dealing with how much the tax bill will actually be, the tax implications of buying vs leasing aren’t worth the time and notepaper needed to figure them out. Unless you’re a largish company, other considerations, like what kind of credit you have and how much you can afford to pay each month, will be of far greater importance.
A Final Word
Many financial concepts seem complicated only because bankers and others in the financial industry use the jargon they’re familiar with to talk about them, not because they’re actually difficult to understand. If you can do basic math, you can get a handle on almost all aspects of personal money planning. If you feel like you should be more in control of your financial decisions, why not fill out the subscription form below to receive more advice everyone can use, in everyday language.