We make choices every day based on personal preference: coffee versus tea, boxers versus briefs, etc.
Some financial choices, however, aren’t so clear cut. After all, we can’t make spending decisions based on preference alone. If we did, we might all be living in luxury for a brief period before landing in bankruptcy.
An obvious, often misunderstood example is buying versus leasing a car. The decision to buy or lease a car seems like one of preference: Would you rather always drive a new car at a relatively low monthly payment or finance a car that you’ll someday own outright?
Of course we have to remind you that, financially, the best way to buy a car is to pay cash for something pre-owned to avoid paying both interest and off-the-lot depreciation.
That said, many people aren’t in a position to pay cash for their cars, and auto loans are the only way they can afford one. Leases, by contrast, allow you to drive a car for a fixed period of time (often three years) while making monthly payments until the lease expires.
Why leases are so tempting
“Probably the main advantage to leasing is a lower payment,” says Jerry Love, a member of the National CPA Financial Literacy Commission. “If you plan to keep the car only a few years — say three years max — then leasing allows you a smaller payment, and you don’t have to worry about the trade-in value.”
The latter concern is important because new cars depreciate the moment you drive them off the lot. And whereas a lease allows you to get a new car every few years, those purchasing a new car will likely hold on to it for much longer, its value dropping with each passing year until it’s time for a trade-in.
“The initial cost of purchasing is higher than leasing; this includes a downpayment as well as a higher monthly payment,” says Allyson Baumeister, a member of the Texas Society of Certified Public Accountants.
For somebody on a budget, it’s easy to see why leases are so tempting: You get a brand new car and a monthly payment that’s lower than a car loan.
But leases are a devil in disguise.
For one, leases have mileage limits where you’re penalized if you drive over that set amount; these penalties can range from five to 20 cents a mile. It’s important to determine ahead of time how you’ll use the car (for short- or long-distance driving) and what those mileage limits are. A cap of 40,000 miles will allow you more wiggle room than 30,000, but you’ll pay extra up front.
What’s more, a lease allows for normal wear to the car, but “if the dealership considers the … the vehicle to have wear and tear above [normal] at the end of the lease, they can charge you extra,” Love says. You can get a better idea of what “normal wear” means by quizzing the car dealership and studying the lease terms.
Why buying is better
Love notes that if the dealership is offering 0 percent financing, and you plan on driving the car for a long time, buying is the way to go. If the financing terms are higher, “Frequently, credit unions will have a favorable rate. And if you have an established banking relationship, you should absolutely check with them for their rate.”
Another member of the Financial Literacy Commission, Clare Levison, notes that car payments will eventually end, whereas lease payments won’t until you turn in the car. “With buying, eventually you will have paid the car off and no longer have the expense of the monthly payment.”
Regardless, “When you lease a car, you make payments for a specified period of time and then at the end of the term you have nothing to show for your money,” Baumeister says. “You own nothing. However, when you buy a car, at the end of the term, you own a car. You can keep that car indefinitely or sell that car for value.”
An example: Buying versus leasing for six years
Some people need to see the numbers, so we looked long and hard for a lease deal that would seem to beat out buying.
We found a promotion for a 2014 Honda Accord Sedan 2014 lease deal listed by Edmunds.com (you can find similar deals here). After $1,999 down, the lease payments are just $199 a month for a 36-month, 36,000 mile lease. The total cost for three years comes to $9,163. Let’s assume you found a similar lease again for another three years. Your total cost comes to $18,326, or $3,054 a year for six years.
The same vehicle had a target price of $20,840 according to car pricing service TrueCar.com. If you put the same $1,999 down and financed the car for 48 months at 2.5 percent, your monthly payment would come to $412.88. At the end of the four-year loan, the total cost to purchase the car (including interest) comes to $21,817. Over six years, your annual cost would come to $3,636 a year.
So far it seems like leasing is way cheaper … by almost $600 a year!
But we’re forgetting something: After the loan is paid off, you own your car. You have an asset. According to Kelly Blue Book, a 2008 Honda Accord LX in mid-grade condition fetches about $10,000 on the private market. So whether you sell the car or apply the trade-in value toward your next purchase, your actual cost of ownership is reduced to $11,817 or $1,969 a year. That’s a savings of $1,085 a year and $6,508 over six years.
Although one of the drawbacks to buying a car is the need for more regular maintenance as it gets older, the savings over leasing should provide plenty of cash leftover.
Is leasing ever a smart option?
Here’s the ugly truth: For most people, leasing doesn’t make financial sense. “Buying a car is almost always better than leasing a car,” Baumeister stresses.
There are some exceptions for business owners or others who can deduct certain vehicle costs. For everyone else, leasing a car should be considered a luxury.
Lease a car if you simply love driving a new car every three years and the cost is worth it to you. As long as you’re aware, it’s fine to make a conscious decision to spend more for your cars than might be necessary.
Why is buying so much better?
Aside from the advantage of ownership giving you an asset — even if it’s a depreciated one — there are other monetary variables to take into account. “The annual insurance cost for a leased car is usually higher than for a purchased car,” Baumeister says. “Also, the driver of a leased car must pay personal property tax on the car. In some states, no personal property tax is owed on a car that you are purchasing. This tax is many times only included in the fine print of a lease contract.”
No matter which option you choose, shop around. Especially with a purchase, “The exact price of the vehicle can vary greatly within your region of the country,” Love says. “The terms of a lease or terms of the note can vary greatly, too. Do some research to identify an expected price, then walk into a dealership equipped with the information.”
If you’re looking for a car, Money Under 30 can help you at every step of the way: