Buying or Leasing a Car: Which Costs Less?
Money Girl explains the costs of buying and leasing a car, the main pros and cons of each option, and how to get the best return on your investment depending on your lifestyle, budget, and financial goals.
Unless you live in a big city that offers public transportation or car sharing services, you probably rely on your own vehicle to get to work, run errands, or have fun. For many people, paying for a vehicle is one of the biggest expenses the have. But knowing whether you should buy or lease a car can be confusing.
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In this episode, I’ll explain the costs associated with both buying and leasing a car. You’ll find out the main pros and cons of each option, and how to get the best return on your investment depending on your lifestyle, budget, and financial goals.
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What’s the Cost of Buying a Car?
When you buy a new or used car, you probably know that you can pay cash or get an auto loan. However, whether you can get approved for a loan, how much the loan will be for, and the interest rate you’ll pay depends on factors such as your credit score, income, and the age of the vehicle.
No matter if the car you want to finance is used or brand new, you generally have to make a down payment in the range of 10% to 20% of the car’s price. For instance, if you want a $20,000 vehicle, you might have to pay $4,000 of your own money in order to receive $16,000 from a lender.
But what if you don’t have any savings for a down payment? Zero- or low-down payment car loans do exist. However, they charge higher interest rates, which means you’ll have higher monthly payments and end up paying much more interest over the life of the loan.
And by the way, don’t confuse a zero-down loan with a zero-interest loan. Sometimes you can get a “zero down and zero interest” special deal, but only in rare cases where a dealer offers it – and you have excellent credit.
See also: Credit Score Survival Kit – a free tutorial to build credit fast!
What Is Being “Upside Down” on a Car?
While it might seem great to pay little or nothing out of pocket for a car, it comes with a huge downside, which is called being “upside down.” No, I’m not talking about your car flipping over in an accident. Upside down is a common term for what happens when you owe more money for a car than it’s worth.
Unfortunately, most vehicles depreciate very quickly. New cars can lose as much as 25% of their value after the first year of ownership, depending on the make, model, condition, and state of the used-car market.
Used cars also depreciate, but much more slowly. That’s why buying a second-hand vehicle can be a great deal; the original owner takes the biggest depreciation hit, not you. The vast majority of vehicles that I’ve purchased have been pre-owned for this reason.
After accounting for depreciation, sales tax, and registration costs, it’s easy to see why you can be upside down right away, especially if you make a low- or no-down payment on a vehicle. Here’s the problem: If you need to sell the car or it gets totaled in an accident, you might not receive enough money to pay off your loan. A buyer or an insurance company will only give you market value for a vehicle, not what you still owe on your loan. You might have the make up the difference from your own savings.
The best way to prevent being upside down on a car loan is to make as big a down payment as possible, so you have equity in the vehicle. That also increases your chances of getting approved for a loan in the first place, reduces your monthly payments, cuts your interest expense, and offsets the inevitable depreciation.
See also: Best Tips to Improve Your Credit Score
What’s the Benefit of Buying a Car?
While buying a car (especially a brand new one) can be expensive, ownership comes with privileges. Here some benefits of buying a car:
- You can drive it as many miles as you want
- You can customize it
- You can maintain it any way you want
- You can sell or trade it at any time
- You may eventually pay it off and drive it for years without car payments
Leasing is another form of financing, so it’s still very important to negotiate the price of the car, known as the capitalized cost, just like you would if you were buying it.
What’s the Cost of Leasing a Car?
Now, let’s look at the cost of leasing a vehicle, instead of buying one. According to Edmundsopens PDF file , approximately 22% of new cars were leased in 2012.
There are multiple factors that go into the calculation of a monthly car lease payment. It depends on the lease term (such as 3 or 5 years), the retail price of the car, your down payment, credit rating, depreciation, dealer fees, and state and local taxes.
Your lease payment must cover the depreciation that will occur during the term of the lease, plus give the dealer a profit for making the deal with you. At the end of the lease you can return the car, or buy it at a pre-determined depreciated value, which is known as the “resale” or “residual” value.
Different makes and models of cars have very different depreciation rates. The higher the residual value, the more it’s worth at the end of a lease, and the lower your lease payments will be. So remember this: vehicles that depreciate the least are the best to lease.
To research vehicle prices and depreciation rates, use terrific resources such as:
- Kelly Blue Book
- TrueCar
- Edmunds
- Web2Carz
- Autotraders
Here’s a quick and dirty tip: Leasing is another form of financing, so it’s still very important to negotiate the price of the car, known as the “capitalized cost,” just like you would if you were buying it. Focus on the capitalized cost more than the amount of your monthly payment.
Monthly lease payments are typically lower than loan payments for the same vehicle over the same term. But, in general, the cost of leasing is more expensive over time because you aren’t building equity in the vehicle.
I mentioned that owning a car comes with privileges; well, leasing a car comes with restrictions. For instance, you can only drive a certain number of miles, such as 10,000 to 15,000 per year, without having to pay a per-mile penalty at the end of the lease. Additionally, you’re responsible for routine maintenance, and can’t make any modifications or upgrades.
Also see: Save Money by Trading a Car Lease
What Are the Benefits of Leasing a Car?
However, here are some benefits to leasing that may make it worthwhile:
- Your monthly payment may be substantially less than buying the same vehicle
- You can drive a new car with the latest options and safety features
- You’ll likely be under a manufacturer warranty during the lease, which protects you from having to pay for major repairs
- You don’t have to deal with selling or trading in your old car
Tips for Buying or Leasing a Car
If you decide to buy a new vehicle, make sure the manufacturer isn’t planning to make major changes to the body style in the next year or two. That could date your car and accelerate its depreciation. It’s better to purchase a new vehicle in its first or second year of a major styling change.
Also consider buying GAP (guaranteed asset protection) insurance, which eliminates the problem of being upside down on a car. It covers the difference between what you owe for a car and what an insurance company gives you if your car is totaled or stolen. It’s usually sold separately, but can also be bundled into the cost of a car insurance package.
If you decide to lease, you can choose to purchase the vehicle at the end of the lease term. That may be a better deal compared to buying another vehicle of the same age—but do your homework to find out for sure. You’ll also have peace of mind knowing the complete maintenance history of that vehicle.
Leasing a car and then buying it when the term is up is a great option if you’re just starting out. You’ll get a lower payment now, but in a few years could be in a better financial position to qualify for a low-rate loan and handle potential future repair costs.
Know Your Financial Goals
To sum up, buying a car, even with a car loan, allows you to have full ownership of it. Leasing one, on the other hand, allows you to use it for a set period of time only, with limited privileges.
If the convenience and benefits of leasing are appealing, make sure you understand what they cost compared to buying. Use a Buy or Lease Calculator to help crunch the numbers.
But if saving money over the long-term is your primary financial goal, then buying a vehicle is best. Make a commitment to drive it until the repair costs begin to exceed the cost of replacing it. Once your loan is paid off, keep sending the same amount of money to a savings or retirement account to easily build wealth for the future.
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Miniature Cars image courtesy of Shutterstock
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
