In our previous post we looked at the Real Cost of Debt and how the time value of money can work for or against you. One question that came up in several comments was the decision to buy or lease a car. Most people will tell you, “it depends.” We’ll examine the benefits of each, but let’s start by addressing what “buying” and “leasing” really mean.
Buying: Purchasing full ownership of the car by taking out a loan against the value of the vehicle. Usually a down payment is required and sales taxes, dealer fees, or other expenses may be added to the total loan amount. Monthly payments include both principal and interest, meaning that each payment you make increases your equity in the car.
Leasing: Purchasing a portion of the vehicle’s total cost for the ability to use it for a specified period of time. Usually a security deposit and/or dealer fees are required at time of lease, and you pay a lease payment plus tax each month over the life of the lease. At the end of the lease, you are required to turn the car back in to the leasing company or, in some cases, to purchase the vehicle.
Now we’ll get into some specific pros and cons of each financing approach:
Buying Pros
- The car is yours to do whatever you want with it. If you want to put a sweet Miley-pumping sound system in it, go right ahead. There are also no mileage restrictions.
- After your car is paid off, every month you keep it reduces your effective monthly cost. As a simple example, if you paid $10,000 for a car and paid it off in 50 months your effective payment is $200 per month. If you keep your car another 50 months, your effective payment becomes $100 per month.
- Generally, insurance costs are lower when buying than leasing.
Buying Cons
- The car is yours. If something breaks and it’s outside the scope of the warranty, you have to get it fixed.
- The upfront costs are high. Down payment, sales tax, and dealer fees are all paid at the time of purchase or rolled into the loan amount.
- The monthly payment is high. Buying means paying for the whole car, and every payment has both principal (cost of the actual car) and finance charges.
- Depreciation can eat away quickly at a new car, and the first payments usually go heavily to interest (not principal). If something happens and you need to sell your car in the first 24 or so months, there’s a good chance you’ll still owe more than the car is worth.
Leasing Pros
- Monthly and upfront costs are lower. Generally you only need to pay dealer fees and sometimes a small deposit to lease a car. Monthly payments are also lower with a lease, since you are essentially paying finance charges only and not principal.
- You’re consistently in new, different cars. Leasing can become a cycle – lease a car, turn it in, and lease again – which always keeps you in a new car.
- Maintenance is usually included. If something goes wrong, you bring it in and have it fixed usually for free. Granted, if you Chuck Norris a side mirror you’ll be paying for it, but most maintenance is covered, even if outside the scope of the warranty.
Leasing Cons
- You’ll always have a car payment. At the end of the lease, you can either lease another car or finance the rest of the car you leased. Either way, you’ll be making payments.
- You cannot modify the car at all. Sorry, no Miley-pumping sound system for you.
- There are mileage restrictions that may range from anywhere under 10,000 per year to over 15,000. Going over will result in mileage charges, which may be as low as 10 cents per mile or as high as 30.
- Insurance costs are generally higher when leasing vs. buying. Also, insurance is usually higher for new cars than older ones, so average insurance costs over the long-term will be higher when consistently leasing.
As you can see, both buying and leasing have psychological benefits. Leasing is a much more hands-off approach to financing – no maintenance, no attachment, and always in the latest and greatest. Buying is more involved approach but the end result is actual ownership of the vehicle. Where the difference between buying and leasing is evident is in the financial comparison. The vehicle that I used for comparison purposes is a 2011 Mazda CX-9. I retrieved vehicle information and leasing terms from Mazda’s site, used this new car from a local dealership for new pricing, and Bankrate.com for 36 month new car interest rates.
The table below highlights the financial difference between buying and financing a 2011 Mazda CX-9. For comparison purposes, I used the same upfront costs in year 1 for leasing and buying, used 36 month lease and purchase loan terms, and set the monthly car budget at $709.58 (the car payment when buying). This budget will be used for four purposes – payment on a monthly lease, payment on a car loan, monthly maintenance after the loan has been paid off, and investing. Any money not allocated to the first three uses will go to investing. For leasing, the amount invested will be constant throughout. For buying, no money will be invested in years 1-3 (while paying the loan) but the full car budget less monthly maintenance costs in years 4-9 will be invested. For this example, we’ll use an annual return of 12% on any invested money.
| Lease Vs. Buy of 2011 Mazda CX-9 | ||
| Price New | $26,697 | |
| Annual | Monthly | |
| 36 Month New Rate | 3.8100% | 0.3175% |
| Market Return | 12.00% | 1.00% |
| Budget | $709.58 | |
| Lease | Buy | |
| Year 1 | ||
| Upfront Costs | $2,594.00 | $2,594.00 |
| Per Month | $349.00 | $709.58 |
| Number of Months | 36 | 36 |
| Year 1 – Year 3 | $15,532.71 | $0.00 |
| Previous Years at FV | $0.00 | $0.00 |
| Total | $15,532.71 | $0.00 |
| Year 3 Equity | $0.00 | $14,855.00 |
| Year 4 | ||
| Upfront Costs | $2,594.00 | $0.00 |
| Per Month | $349.00 | $25.00 |
| Number of Months | 36 | 36 |
| Year 4 – Year 6 | $11,821.30 | $29,489.62 |
| Previous Years at FV | $22,223.72 | $0.00 |
| Total | $34,045.02 | $29,489.62 |
| Year 6 Equity | $0.00 | $8,941.60 |
| Year 7 | ||
| Upfront Costs | $2,594.00 | $0.00 |
| Per Month | $349.00 | $50.00 |
| Number of Months | 36 | 36 |
| Year 7 – Year 9 | $11,821.30 | $28,412.70 |
| Previous Years at FV | $48,710.55 | $42,192.83 |
| Total | $60,531.85 | $70,605.53 |
| Year 9 Equity | $0.00 | $4,110.40 |
Let’s examine the financial situation after Year 3, Year 6, and Year 9
Year 3 – At first glance, leasing looks like the winner over the first 3 years of our example. The “Lease” investment account has $15,533 while the “Buy” investment account has exactly $0. Keep in mind, though, that on the last day of year 3, the leasing company kindly takes their car back. If you had bought this car and made payments, you’d have no investments and a 100% paid-for car. Based on this vehicle’s depreciation schedule, it’d be worth approximately $14,855. If you kept up with the car’s maintenance and appearance in those three years, it could be worth more. The element of risk is something to remember as well. The good investments made in years 1-3 could always be wiped out in subsequent years, but once your car is paid off the risk of losing it for any financial reason is essentially nil.
Year 6 – On Day 1 of Year 4, it’s time to re-up the lease. I used constant lease terms but inflation will most likely mean it’s more expensive than Year 1. $2,594 comes out of the returns for Year 4-6 to pay for those costs while you continue to make lease payments on your newer car. The only expense associated with buying at this point is monthly maintenance, which I’ve estimated as $25 per month, while the remainder goes into the investment account. The leasing investment account now has only $4,500 more than the buying investment account after six years. If you leased it’s time to turn your car back in. If you chose to buy, you still have a six year old car worth approximately $8,900.
Year 9 – By the end of Year 9, the “Buy” investment account has overtaken the “Lease” account by $10,000+. Gains made by leasing in Years 1-3 have been eclipsed by the significantly higher investment amounts buying allowed once the car was paid off. Even after nine years, a well taken care of car should have many more miles to drive. Any upgrades you would need to make – stereo, paint job, even a new transmission – could easily be afforded given the excess money invested over the previous six years. Again, at the end of year 9, leasing yields over $60,000 in investments but no car. Some of that money will go to either paying cash for a new/used car, or beginning another lease.
Buying has significant financial advantages over leasing in the long term. When risk is considered, the financial decision is a no-brainer. There is always risk that investments will lose value and gains could be eliminated, while the risk of losing your car once it’s paid for is essentially nil.
So why do people lease? In my opinion, leasing is a psychological decision. Some people like constantly having new, different cars for a variety of reasons – appearance, safety, and technology among them. If leasing a car is an affordable luxury, then there’s nothing at all wrong with that. Every day, consumers make psychologically pleasing decisions that are poor financial ones. (If none of us ever did this, we’d probably all be rich and miserable.) I think leasing is a very expensive example of this.
The next time you’re watching a show live and see a car commercial (or, more likely, fast forward over a commercial on DVR and rewind to watch), look at what’s being offered. The commercial will usually show a pretty reasonable monthly payment, but it’s almost always a payment on a 36 month lease. Occasionally, a car company will quote a purchase price, but almost never will a car company quote a monthly purchase payment. Dealerships, commercials, and websites will often push leases as they are much more profitable to the car company than an outright purchase is. What does that mean to the consumer? Car companies are in business to make money. If it’s their most profitable line of business, is it a good financial decision for us?
Image Flickr dhilowitz.
