Most of us have been faced – or are likely to be faced at some point – with the decision of leasing or buying a car, given that driving remains one of the most efficient modes of transportation. Unlike other major financial decisions e.g., buying a home, with a car there isn’t the concept of “equity” and instead car owners must deal with concepts such as depreciation and salvage value, which complicates the decision process. Currently in the United States auto lenders, banks and credit unions are offering very low interest rates on auto loans which is another important input into the lease vs. buy decision. For example, a mid-sized credit union in the U.S., Ontario-Montclair School Employees Credit Union (OMSEFCU) is offering a 1.99% APR on new and used auto loans with loan terms of up to 5 years. In the following sections we discuss how consumers should think about the lease vs. buy decision.
The option to lease a car means that you can drive the car off the lot without owning it. You make an initial down payment that covers various taxes and other costs and sign an agreement to pay the dealer (which is often also the company financing the car) a monthly fee for using the car for a set amount of time. After the leasing period ends, you return the car back to dealer.
Benefits of Leasing
First, leasing is initially cheaper than buying, this is because the lender calculates the lease payment assuming they will be getting the car back at the end of the lease period. As a result, you’re really getting charged for a portion of the value of the car. If you buy a car outright, then regardless of whether you pay cash or finance it, what you pay is tied to the entire value of the vehicle. The second benefit of leasing is that you don’t have to worry about depreciation – once you drive a car off the dealer lot, it loses value. If you own the vehicle, then that would be an immediate hit to your asset value. With a leased car you don’t have to worry about this at all. The third benefit is that leasing provides you with flexibility: once the lease is up you can sign a lease for a new car or hand over the keys and move on. You don’t have to concern yourself with finding a buyer for the car. If for instance you purchased a car that was very popular one year but unpopular in subsequent years as an owner this limits your resale options, but if you lease the car, it’s an irrelevant development to you.
The Downside of Leasing
One of the most significant drawbacks of leasing is that it can be very limiting in terms of how much you use the car. Car leases come with conditions including limits on how many miles you can put on the car each year. The amount you pay each month for the lease will increase or decrease depending on how many miles you plan to put on the car. This becomes an issue if your circumstances change. For example, if you switch jobs and now have a much longer commute which requires more driving than you anticipated. While there isn’t a concept of equity when it comes to cars, car dealers do embed a depreciation cost into the lease cost. What this means is that over the course of many years of leases you could be paying a similar amount to what you would have been paying if you just owned the car outright. Further, leasing companies expect you to bring the car back in at least good condition and therefore you’re always worried about potential damage being done to the car.
It Comes Down to Your Usage and Financing Options
The first step in deciding whether you should lease a car is to make an honest assessment of how much you plan to use the car. If you drive often and drive long distances, leasing will be quite expensive and might not make sense. The reason for this is that from the perspective of the dealer, the more you drive the vehicle the more it depreciates and so they need to be compensated for that. Coming up with a reasonable estimate of how much driving you expect to do each year should be the first step. The second step is to look at the financing terms being offered by auto lenders. Although rates have started to increase and auto loan rates have therefore increased compared to where they were in 2021, rates remain quite low. The auto loan rate is the effective ownership cost and is what should be used to compare leasing vs. buying. For example, let’s assume there is a $30,000 car that is offered for a 24-month lease and that would be worth $25,000 at the end of two years. The cost of the lease is $200 a month. Therefore, at the end of 24 months your total ownership cost (excluding servicing and repairs) would be $4,800 but you must then return the car to the dealer. If instead you financed the car (let’s use the 2% rate being offered by OMSEFCU for 5 years) then over the two year period you would have paid $13,200 in total in principal payments and interest. However, you would own the car, and can sell it $25,000 or continue using it. In this circumstance, buying is the better financial decision than leasing.
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