Recently, a reader named John wrote in asking about leasing vs. buying a car. Here is John’s question:

I was wondering what your input is in regard to buying vehicles? For example, I’m in the process right now of selling a vehicle for a good buck. Would you suggest reinvesting this money in a used vehicle selling for a small price with low mileage? Or would you suggest leasing? Overall, every vehicle depreciates once you make the buy, so what would the be the best decision here? Leasing or buying used?

It’s a question I hear a lot. Monthly lease payments can be a lot lower than the payment on a loan to buy the car. While this can make leasing look more attractive, leases are rarely a good deal. Let’s break John’s question down first, and then we’ll look at the pros and cons of leasing vs buying. John’s question is really two questions folded into that one. You can pay cash for a car whether you lease it or buy it. So the first question is this: Are you going to finance the acquisition of a car – whether you lease it or buy it – or are you going to pay cash? My strong preference is to pay cash for a car. And those that do pay cash, almost always buy the car. If you do plan to finance the acquisition, we move to the second question. Should you finance the car with a lease or with a more traditional loan? The way that we’ve broken this down underscores an important point. Leasing is a form of financing. A lease is just another way of financing the acquisition of a vehicle (unless you pay cash for the lease, which nobody does). There are significant differences between leasing a car and paying for one with a loan. But just keep in mind that a lease is a way to finance a car.

Should you just pay cash?

If you’ve followed this blog and my podcast, you know I’m a big believer in paying cash for a car. In most cases, for that reason alone, I don’t think leasing is a good option. Most people who either lease or borrow to acquire a car end up gettng a car that’s more expensive than they can reasonably afford. I’ve certainly done that in the past. I’ve never leased a car, but as I look back on the cars that I’ve purchased, when I was borrowing to buy a car, I ended up spending more than I should have. And when I pay cash for a car – like the last Toyota Camry I bought – the fact that I paid cash for it absolutely effected how much I spent. As I was looking for cars and thinking about the money coming out of my bank account, it really put the brakes on overspending. The best way to get a car is usually to pay cash.

How do leases work?

Let’s talk about how leases work a bit. There’s no single form of lease, but there are certain standards that you’ll see most often. Typically, a lease is for three years. You can get one or two year leases, but most are for three years. In addition to the length of the term, there’s a limit to the number of miles you can put on the car. A standard mileage limit is 12,000 miles per year. So in a three-year lease, you’d have a total limit of 36,000 miles. You can drive it more than that, but once you go over the 12,000 miles per year (or however many total miles your lease states), you end up paying a fee for each additional mile over the limit. From what I’ve seen, the fee typically comes in at around 20-25 cents per mile. If you put an extra 3,000 miles a year on your car – which isn’t hard to do – that could add an extra $750 to the lease at a 25 cents per mile rate. So it’s essential to understand mileage limits. And at the end of a lease, you either return the car or purchase it.

How are lease payments calculated

Lease payments are calculated using the purchase price, the residual value of the car at the end of the lease, your down payment, capitalized fees, and what is called the money factor. It’s really not complicated, so let’s walk through the steps. The first thing they’ll calculate is the residual value of the car at the end of the lease. On a three-year lease, for instance, they’ll calculate what the car will be worth at the end of three years. The formula usually involves a percentage of the new price of the car, which varies from car to car. As a rule of thumb, though, you can assume that after three years, the car’s residual value will be about 50% of the new value of the car. (Although this will be higher with some cars.) The residual value is then subtracted from the price of the car to arrive at the car’s depreciation. If you have a $20,000 new car, for example, at the end of the three years we’ll assume it’s worth $10,000. It has depreciated by $10,000 during that three-year lease. And that’s the portion of the car you’ll pay for – this loss of value over the term of the lease. But there are other factors rolled into how your payments are calculated. For instance, there are fees and taxes associated with a lease. There’s also what’s called the “money factor.” This is basically interest associated with your monthly payments, and it can be significant. So when you factor in the depreciation, fees, and “money factor,” then divide that by the number of months in your lease, you’ll get your monthly payment. You can lower the monthly lease payment by making a down payment, similar to buying a car.

Key factors in a lease

Now lets turn to some key factors about leases you should know if you decide leasing is the best option for you.

The price of the car

The first factor in a lease is the price of the car. When you go to buy a car, it’s common to negotiate the sale price. Depending on the car you buy, the price you pay could be significantly less than the car’s sticker price. Negotiating the purchase price, even on a lease, is critical. The car’s residual value subtracted from its base price is the starting point for your lease payment. So the lower you can get that original price, the lower your lease payments will be. When it comes to a lease, many consumers don’t negotiate the price. Instead, many focus on the monthly payment. This will lead you to paying a lot more for the lease than you otherwise would. So start by negotiating on the base price of the car, and go from there. New York Times writer Marc Frons recently wrote an article about his experience leasing a car – including the mistakes he made during the process. He talks about how he didn’t negotiate the actual price of the car because he was too focused on the lease payment. Like many others, he was focused on the monthly payment. Don’t make the same mistake. Negotiate the cost of the car even on a lease. As an added tip, never negotiate at the dealer. Instead, negotiate primarily via email or by phone. This takes away the dealer’s advantage of shuttling between you and some unknown manager, dragging the process out.

The residual value

The second mistake is not looking at the car’s residual value. There are formulas – based on the specific car – that determine its residual value. This article from Edmunds talks about how important the residual value is. The key to remember here is that different cars depreciate differently. Some depreciate more quickly, while others depreciate more slowly. The residual value for a car that depreciates quickly will be lower, and – all other things being equal – that will increase the cost of your lease. So if you can lease a car that depreciates more slowly, you’ll have lower lease payments.

The money factor

As I mentioned before, the money factor is the dealer-calculated interest portion of your payment. This is where, to the surprise of some, your credit score and credit history will absolutely affect your lease payments. When you look at a lot of lease agreements, they show your monthly payment broken down in a fairly simple way. But the money factor can get totally lost in this. So you definitely want to understand the money factor. As you’re considering different dealerships, understand that each dealer will charge a different money factor.

Fees

The fourth mistake that folks make with a lease is not understanding all the fees that come with it. This, I think, is one big reason why leases are rarely a good deal. Let’s just talk about a few of the fees associated with a lease: Acquisition fee: The acquisition fee isn’t entirely surprising. There are acquisition fees when you buy a car from a dealer, too. In one lease I examined recently, this fee was $700. That’s a pretty significant fee. Rent charge: You may wonder why there is an additional rent charge to a lease. This is a common part of a standard lease. In Marc Frons’ New York Times article, his rent charge was about $205, which was added to the total up-front cost of leasing the car. Early termination fees: If you want to get out of a lease early, you’ll have to pay fees for the privilege. Excessive wear and tear: There will be extra costs for excessive wear and use of the vehicle. If it’s over and above what the dealer considers normal, you could end up paying more when you return the car. Of course, that leaves open the possibility of a dispute with the dealer, which is something to keep in mind. Over mileage fees: As I mentioned earlier, there are additional fees if you go over the mileage limit. In some leases, the mileage limit is 10,000 miles per year, but the 12,000 miles per year limit is very common. And some leases even go up to 15,000 miles per year. But if you go over that, you’ll typically pay 20-25 cents per mile. On the flip side, there’s no refund for coming in under the mileage limit. It’s kind of a “heads they win, tails you lose” sort of situation. Purchase option fees: If you decide that you like the car and want to buy it at the end of the lease, the dealer is going to charge you a fee for the privilege of buying the car you’ve been driving for three years – on top of paying for the vehicle. In the New York Times article, the purchase option fee was $300.

The bottom line of leasing

As you can probably tell, I think leasing a car is a bad idea in most instances. Most people lease vehicles because it’s the only way they can afford the car they want. But this results in paying more for a car than they should. That’s my opinion, and it’s what I told John. But if you or somebody you know is considering a lease, ask these questions first:

• Why aren’t you paying cash? Yes, it may mean you can’t afford the car you want, but it’s a better move in the long run.
• Is this the least expensive car the meets your needs? Usually, people lease expensive cars because they can “afford” the monthly payment – sometimes barely. So get the least expensive car that will suit your needs, and you’ll be better off.
• What about your other financial goals? Do you have credit card debt? School loans? Are you maxing out your retirement savings? Do you have an emergency fund? If you have other debt and aren’t saving enough, you have no business leasing a car – or even borrowing money to buy a more expensive car than you need.
• What will you do at the end of the lease? If you do lease a car, what’s your ultimate plan? A lot of folks don’t negotiate the price of the car, or consider the residual value. They have no idea what the money factor is, and they just pay the fees. And then at the end of the lease, they can’t afford to pay cash to buy the car, so they finance it. As a result, they’re paying a fortune for the car.

Those are my thoughts on leasing a car. Pay cash if at all possible, and otherwise consider regular financing for a used car that’s more affordable. Let me know if you have other thoughts or opinions in the comments.Leasing a car may be an option for you in certain circumstances. But it can also cost you more money than it's worth. We explore your options here.

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