Leasing vs BuyingYour next car
Trying to decide if leasing is right for you? Before you sign on the dotted line, take a look at this article (print it and take it with you to the dealership!) for a better understanding of what leasing really is. We've compiled a brief explanation to try to take some of the mystery out of leasing a new car or truck. Most of us understand the process of getting a car loan ... you decide which car you want to buy, negotiate an acceptable price, decide how much money to put down and make sure the monthly payment will fit into your budget. It's pretty easy!
So why is leasing so hard to understand? And is it as good as some say it is? Let's start with the basics.
Leasing vs Loans
The main reason most people lease a car is the lower monthly payments. Does this mean a lease is the best option in the long run? It really depends on your reasons for leasing.
Is leasing less expensive than a car loan?
It may cost you less to lease a car on a monthly basis, but in most cases, it may cost you more in the long run. Why? If you make all of the scheduled monthly payments and opt to buy the car at the end of the lease, you will have paid more for the car than if you had a car loan from the start. This assumes you are going to obtain a car loan for the remaining balance owed (or the residual value) at the prevailing used-car interest rates.
Why are the monthly payments less on a lease?
To answer that question we need to compare leasing with loans. When a car is purchased using a loan, most consumers check the current interest rates before they buy. Then they go to their local dealer and negotiate the selling price of the car. Once they agree on the selling price, most people then determine how much money they will put down. The monthly payment is calculated on the negotiated selling price, the lowest interest rate and any down payment or trade that will be applied. The monthly payments are based on clearly disclosed factors that can be easily understood by most consumers.
Enter leasing . . .
In a lease, instead of making payments until the loan is paid to a zero balance, your payments are structured around the predetermined end of term value or "residual value" of your new car at the end of the lease term. Why are your monthly payments based on the end value of the vehicle?
The theory of leasing . . .
The moment you drive your new car off the dealer's lot, the clock starts ticking. But you aren't losing time, you're losing money. Every day your car goes down in value (it's a depreciating asset). How quickly a car loses its value (or depreciates) over the term of a lease is determined by the entity that owns the car until the balance is completely paid off — the leasing company.
In most lease contracts, the dealership through which you arrange the lease is not the owner. Typically, when you negotiate a price, the leasing company is agreeing to buy the car from the dealer based on the price you negotiate. Since the leasing company is allowing you the full use of its vehicle without full payment, they charge you a rate factor (lease interest rate) until you pay it back. The leasing company determines the structure of the lease, including the value of the car at the end of the lease, the lease interest rate and any mileage stipulations.
Some cars are better values to lease based on consumer trends (or variables). Some of these variables include the kind of car you select and how well it holds its value, your individual driving habits and any factory-sponsored lease rate reductions. Long before you lease a vehicle, these variables have been put into a formula in order to determine your monthly payments.
This is the main reason why leasing is so confusing. The leasing company (or lessor) determines how much a car will lose value (or depreciate) over the term (number of months) of the lease and how much the cost of borrowing money (or rate factor) will be.
Why is leasing so hard to understand?
The reason most people don't understand leasing is because they aren't familiar with the idea behind it. The most important thing to remember before you lease a car is to know the right questions to ask. The following list of questions should be answered before you lease a car:
- What is the initial price of the car I am leasing? (CAP Cost)
- What is the lease rate I am being charged by the leasing company? (Cost of borrowing money)
- This lease is for how many months? (Length of term)
- How much money will I pay at the beginning of the lease? (Entry fees)
- How much do I owe if I want to buy the car at the end of the lease? (Residual value)
- What is the maximum mileage this lease allows without a penalty?
- If I go over the mileage limit, how much will I be charged for extra mileage? (Usually defined in cents per mile)
- Does the amount of insurance coverage I carry increase if I lease?
- Does the leasing company offer standard GAP insurance? (To pay off the loan in full in case of an
- What happens if I decide to terminate the lease early? (Prepayment penalty)
If you want to calculate a lease payment, you need to understand these terms:
- Lease Term — The number of months for which the lease is written.
- CAP Cost — Initial price of the car.
- Residual Value — Wholesale value of the car at the end of the lease.
- Lease Rate — Comparable to an interest rate or cost of money.
The three parts of a leasing payment: Monthly depreciation, monthly lease charges and sales tax. Add all of these components together and you will have your total monthly lease payment.
Here's The Algebra Part!
Depreciation Portion - Required to be disclosed on all contracts, this amount is applied to the principal balance. Subtract the residual (end value) (Y) from the initial cost (CAP Cost) of the car (X). Divide (/) the balance by the number of months in the lease (W).
(X - Y) / W = monthly depreciation.
Lease Charge Portion - Equivalent to an interest rate, the lease rate must be known to figure out a lease paying. It is usually disclosed as a factor beginning with two zeros (e.g. .00375, .004). This is the cost of using the leasing company's money until the lease is terminated. Add the initial cost (X) plus (+) the residual value (Y). Then multiply (·) the total by the lease rate factor (z).
(X + Y) · z = leasing charge per month (added to the depreciation = your base payment).
Sales/Use Tax Portion - Tax is paid monthly and calculated on the base payment (depreciation + lease charge). When added to the base payment, you arrive at the total monthly lease payment.
Need an example? Let's pretend you want a four-year (48 month) lease:
MSRP - Manufacturers Suggested Retail Price = $20,500 (before any discounts)
CAP Cost - (Negotiated price!) = $18,900
Residual Value - (Based on the MSRP · 45%. 20,500 · 45% = $9,225) = $9,225 (residual end value)
Lease Rate - .00375 (.00375 · 24 = 9% interest)
$18,900 - $9,225 = $9,675/48 = $201.56 (Depreciation)
$18,900 + $9,225 = $28,125 · .00375 = $105.47 (Loan charge)
$201.56 + $105.47 = $307.03 (Base Payment)
$307.03 · 7.75% (tax; your tax rate may vary) = $23.79
$23.79 + $307.03 = $330.82 (Total Payment)
Whew! If you've made it this far, you are to be congratulated! Leasing is a complicated mixture of numbers and equations that elude most people. But by educating yourself you can protect against potential miscalculations that could end up costing you hundreds or even thousands of dollars.