Leasing is for rich people and buying is for people who want to stay rich. Let us examine the differences between buying vs leasing so that you can decide for yourself if buying is better for you or leasing is.
In my opinion, the primary (and perhaps) only advantage leasing offers over buying is the convenience of having a new car every 2-3 years. Still go through the complete post and decide for yourself.
Definitions – Buying vs Leasing
Let us start by defining buying vs leasing:
Everyone knows what buying a car means – it means you own the car, it is yours, you can use it for as long as you like, and sell it whenever you like.
On the other hand, leasing is renting. You do not own the car. The dealer owns the car, he rents it to you for a fixed period of time (usually anywhere from 2 to 4 years). You pay rent every month. At the end of the lease term, you return the car to the dealer.
Arguments people make
Many a times people say ‘Leasing makes sense for me because this way I can get a brand new car every two years’ – oh well, who is stopping you from selling your car after 2 years and buying a new one? I agree that selling a car will take some effort, and therefore the primary advantage of leasing a car vs buying is the convenience with which you can get a new car. You just go in, return this car, sign paper work, get the new car, and drive off.
They say ‘Leasing is the right thing to do for me because I cannot afford the monthly payments if I buy the car’ – then my friend, you are trying to live beyond your means. You should perhaps consider buying a smaller cheaper car OR still better consider buying a pre-owned car. Ask anyone who has owned a car, the only big difference between a brand new car and a car that has been used for a year is the ‘new factory packaging smell’ – the new smell that lasts for may be a month or so.
They say ‘Leasing is cheaper because the monthly payments are lower’ – Monthly payments are lower but you are not building equity in the car, you can lease the first car for 2 years, second car for 2 years, and third car for 2 years – and still own nothing; while if you buy a car and make monthly payments, the car will be yours in 5 – 7 years time and then you will not have monthly payments.
The above analysis is based on hundreds of buying and leasing options I have seen. Leasing invariably turns out to be more expensive. Remember – the dealer wants you to lease because they make more money on leasing. When you return this car after your least term, they will sell it to someone else and make a profit. They will also make money because you will be doing business with them again, to get a new leased car – while in case of buying, you buy the car and you are done (apart from some periodic maintenance/ servicing needs).
Another disadvantage of leasing is the mileage restriction – if you do not have a very good idea about the miles you will be driving, then you will invariably lose money. Either you will take on a lease with more miles than you need (and pay for it) OR you will end up using more than what you signed up for and pay ‘excess mileage rate’ (which is not cheap).
Leasing allows for regular wear and tear. Anything excessive will cost you money. And yes, a small ding or a scratch is considered excessive wear and tear. So if you are not a perfect driver or are sometimes just unfortunate, then leasing will prove to be more expensive.
Last disadvantage of leasing I would like to mention today is loss of flexibility. With the lease, you will have to change your car in a very narrow window (the dealership will start to call you a few months before lease expiry with ‘great’ offers and they will usually let you go month-to-month after the lease expires). While with buying, you have complete control over when you are ready for a change.
Still want to lease?
After weighing all the pros and cons of buying vs leasing, if you still think leasing is right for you, then familiarize yourself before you visit a dealer.
MSRP is Manufacturer’s Suggested Retail Price (List/Sticker Price). This is value is used to calculate the Residual Value of the car.
The capitalized cost (cap cost) is the equivalent of the selling price, which you want to get down as low as possible.
The residual value is the estimated worth of the car at the end of your lease. This is the price at which the dealer is taking back the car from you at the end of your lease. When you got the car, it was worth the cap cost, when you returned it it was worth the residual value. So what did you pay for the car to use it for lease term? Cap cost MINUS residual value.
Remember – the higher the residual value, the better it is for you. Usually residual value is calculated as a percentage of the cap cost. I remember a friend of mine having 68% of the cap cost as residual value.
Since you are paying ‘cap cost minus residual value’, your monthly payments are determined by these two numbers, rather by the difference between these two numbers, plus an interest charge (money factor). Raising the residual value will benefit you; so will lowering the capitalized cost or the money factor.
Money Factor is a decimal number (analogous to the interest rate) that is used to calculate the lease payment. To convert the money factor to interest rate, multiply it by 24. This number may be converted to an approximate interest rate by multiplying by 2400. Example: A money factor of 0.00417 converts to an interest rate of about 10%.
Every salesman (well every smart salesman) will again and again try to make you focus on the monthly payment but remember monthly payments can be very misleading if looked at in isolation. You need to look at the cap cost, residual value, MSRP, upfront down payment, permissible mileage, excess mileage fee, money factor, acquisition fee, disposition fee, and an early termination fee.
If you are able to understand all of this, then excellent. If not, here is a simple successful formula. First fix the term you would like the lease for and the mileage. (Tip – never even think of a lease term that exceeds the manufacturer warranty of the car). Typical lease term is 24 – 48 months, and typical mileage packages offered per year are 8,000/ 10,000/ 12,000.
Let us say you need a lease for 3 years / 12,000 miles per year. Next fix a dollar amount that you are willing to pay upfront – it is often zero but amounts up to $3,000 are not uncommon. Let us say you decide to go with zero upfront down payment.
Till now, you have decided that you need a lease for 3 years/ 12,000 miles per year/ zero down payment. (And hopefully you have the exact specifications of the car you need – the make, model, accessories).
Now get a quote from 3 – 5 different dealers in the neighborhood for ‘your car specs’/ 3 years/ 12,000 miles per year/ zero down payment. This way, it is easy to compare their quotes. They might still give you a lot more than you ask for – for example, different scenarios of what happens if you put money down etc, but just ignore all that. Just look at the MSRP and the monthly payment.
The dealer will not always have a vehicle with your exact specs available, so they will send you a quote for an available vehicle that is ‘just more’ than what you need – this will be reflected in the MSRP. Let us say the MSRP of the exact vehicle you need was $18,000 because you did not need an all wheel drive. But if the dealer only has vehicles with all wheel drive, then the MSRP will be $19,000. It is up to you to decide if the additional feature that you are getting is worth the additional cost.
Real life Example
I realized that a real life case study about buying vs leasing car will add a lot of value to this post. So I reached out to one of the largest Lexus dealerships in the country and received the following quotes for buy vs leasing the exact same car.
First thing to note – the dealership tried real hard to get me physically to the dealership. It is a standard sales tactic – most dealers do not want to compete purely on price point, so they will try whatever they can to physically get you to the dealership and then sell the car. After multiple emails back and forth, I finally managed to get this document that shows the exact calculations right from MSRP (Vehicle price) to OTD price (Out The Door).
Second – what this document is still not showing me is the money factor and residual value that the dealer used to calculate the monthly lease payments. I reached out to the dealer again and found out the two numbers: money factor is .0015 and the residual value is 62%.
Now let us understand how the monthly lease payment is calculated: The monthly lease payments consists of 3 costs: depreciation cost, finance cost, and sales tax cost.
Depreciation cost: Simply stated, depreciation cost pays for the loss in value of the car over the period you are going to use it. Depreciation cost = depreciation over the lease term divided by the number of months in the lease. Total Depreciation = Current value – residual value = $37,282 – 0.62 * $37,282 = $14,167.
Monthly depreciation cost = $$14,167 / 36 = $394.
Finance cost: These are finance charges, you will be using a $37,282 car from the first month itself but will pay only $508 to begin with. Finance costs are calculated using the following formula:
Finance costs = (‘Final car price’ + Residual value) * Money factor. In our case, it is: ($37,282 + 0.62 * $37,282) * .0015 = $ 91.
Sales tax cost: Sales tax cost is simply your total depreciation multiplied by sales tax rate divided by the lease term. So you pay sales tax only for the ‘vehicle’ you will consume during the lease period. In our case, sales tax cost = 6% * ($37,282 + 0.62 * $37,282) / 36 = $24.
Add these three numbers: $394 + $91 + $24 and you arrive at the magical number that the dealer quoted for monthly lease payments $508.
Compare – buying vs leasing
Now we are ready to compare the buy option vs the leasing option for the options that the dealership gave me. $37,282 for outright buy and $508 monthly for 36 mon/ 12k miles lease.
- In the leasing option, the dealer is charging you an interest rate (included in financing cost) of approximately 2400 * money factor. So in this example, the dealer is charging 2400 * .0015 = 3.6% interest rateI had told the dealer that my FICO is 805 so assume excellent credit. At my credit, my credit union charges me 1.94% on auto loans.One of the challenges with leasing is – you cannot choose who to finance with, you have to go with the dealer. While you can finance (and/ or re-finance) with any lender you like.
- Let us compare this to financing option – $0 down, 1.94% interest rate, loan duration 7 years, the monthly payment comes to $475.What? Really? Yes, really. So per month payments are lower in the buying option vs the leasing option. And at the end of 36 months, you would have built some equity in your car if you buy it using a loan. You will not own it completely because you still have 4 more years of loan payments.To be more scientific, you would own $15,361 in the car. And that too, after you are paying $33 per month less in the buying option vs the leasing option.(Calculations – you pay $475 every month. In the first 36 months, you would have paid a total of $17,100 – $1,740 of it is interest and $15,361 of it will be principal.)
Car purchase is one of the bigger financial decisions that people make (biggest after marriage, education, and house). So please do yourself a favor and follow these 5 simple steps to save a few thousand dollars.