When it's time for a new car, several options are on the table, from choosing the make and model to the various trim options. However, one critical decision during this period is between financing (buying) the car or leasing the car. It helps to understand the pros and cons of leasing vs. financing a car and what these options entail.
Financing Vs. Leasing: The Key Difference
When buying a vehicle through finance, it's with the understanding that you'll own the vehicle at the end of the finance term. With a lease agreement, the vehicle is returned to the lessor at the end of the term.
Pros Of Financing A Car
One primary benefit of financing a car is that the payments go toward owning the car, which is considered an asset. Other potential pros of buying a car include the following:
- Ownership: Once the buyer pays that final installment at the end of the finance term, they can decide what happens to the asset. They can keep it for as long as they want or sell it. There's no obligation to trade in or sell the car at the end of the term.
- There are no mileage limits: For those planning to put a lot of miles on the car, financing it might be more cost-effective. There are no fees charged at the end of the term regardless of the miles on the odometer.
- A car owner can customize the car: Buying a car means being able to modify it without worrying about it since the car isn't returned to the dealership at the end of the term.
- Excess wear and tear won't attract a penalty cost: Wear and tear are to be expected when using a car. However, when you're financing a car with the intention of owning it at the end of the term, you don't have to pay an extra amount to the financial institution to cover the excess wear and tear.
Cons Of Financing A Car
Cost is a factor when buying a car and can be considered a drawback. Other potential cons of buying a car are:
- Depreciation: Depreciation is the drop in value your car experiences from when you buy it to when you sell it. Buying or financing a car outright means contending with depreciation. Some new cars typically depreciate by more than 20% in the first year. This means that if you were to sell it within the first year, you might be upside down on the finance, which is owing more to the lender than what the car is worth.
- Higher monthly installments: The monthly payments made toward a finance agreement go toward paying off the car. The buyer will own the car at the end of the term but at typically a higher installment than with a lease agreement.
- To avoid being upside down on finance when financing a car, a downpayment of 20% or more is recommended.
What Does It Mean To Lease A Car?
During a car lease, you as the lessee (the person taking the lease) pay a monthly payment to use the car. It's much like a rental contract, where the car is returned at the end of the term. These terms typically run for 24 to 48 months. Consider the pros and cons of leasing a car before deciding to go this route.
Pros Of Leasing A Car
There are instances where leasing a car might be a better fit. Some of the benefits of leasing a car include:
- Lower monthly installments: Car lease payments are typically less expensive than a finance agreement for the same make and model of car. However, these installments don't necessarily go toward paying for the car and are more like rental installments.
- New car every few years: There are several reasons why having a new car every few years may work. The lessee can lease a new car with access to the latest safety and technology, and warranties are in place.
- Flexibility: When a leased car turns out to be problematic, the lessee can return it to the lessor. This might not be as simple when a vehicle is financed.
- Fixed price: The lease buyout price is determined in advance. If the car's value doesn't depreciate quite as much as predicted by the lessor, the lessee might end up being in a better equitable position at the end of the term. If so, they can buy out the lease and trade the car in for a higher value.
- Warranty: Lease periods are usually short, and the manufacturer's warranty on the car is likely still in effect.
- Smaller downpayment: Lease agreements still require a downpayment, but it's often less than taking out finance. In some instances, lessees may not have to put any money down as a downpayment.
- The option to own: You may be able to buy the car outright after the period through a lease buyout . The purchase cost could be a significant amount which you would have to settle through finance or by using personal savings.
Cons Of Leasing A Car
A car lease doesn't work for everyone. Here are some of the possible drawbacks:
- Mileage costs: A lease agreement often restricts you to 12,000 or 15,000 miles per year. Those who exceed these restrictions typically pay an excess mileage charge of 10 to 25 cents per mile.
- Wear and tear: It's important to return the car to the agency in good condition. If not, you can face charges for excessive wear and tear. The types of driving events that may add excessive wear and tear, and additional mileage, include family driving trips, long commutes, or using the vehicle for ride share or part-time delivery jobs.
- Cancellation costs: If the lessee needs to end the lease before the term ends, they can expect to pay penalty costs, called a termination fee. This is because the lessee covers the costs of the market value decline, which happens more rapidly at the beginning of a lease. However, If the lessee just buys out the lease, there's usually no termination cost. See the example below of how cancellation costs might be calculated.
Cancellation Cost Example
Here is a closer look at how the fees might be calculated. Jenny leases a car where the agreed-upon value is $20,000, and the residual value is $10,000. Jenny provides a downpayment of $2,000. The lease term is three years with an APR of 5%.
First, you'll subtract the downpayment from the agreed-upon value to get the capitalized cost:
$20,000 - $2,000 = $18,000
Then, you'll subtract the residual value:
$18,000 - $10,000 = $8,000
Divide this amount by the term to get the monthly depreciation:
$8,000/36 = $222.22
Next, convert the APR to a money factor
0.05/24 = 0.002
Now, you'll need to add the capitalized cost to the residual value and then multiply this by the money factor for the monthly interest costs:
($18,000 + $10,000)*0.002 = $56
The monthly lease payment would be the monthly interest costs and depreciated added together:
$56 + $222.22 = $278.22
The termination cost factors in the lease costs over the remaining term. You would add together all the remaining payments left on the lease, subtract the unpaid finance charges, and then subtract the realized value of the car. The amount that's left over is what Jenny will be billed for. Using the figures in the example above, if Jenny decides to end the lease with 12 months left on the agreement and there are no additional costs with a realized value of $12,000 (an estimate of what the car is worth, usually the market value), the calculation should look like the following:
To determine the balance, the monthly payment needs to be multiplied by the remaining term and added to the residual value:
($278.22*12) + $10,000 = $13,338.64
You would then subtract the realized value to determine the costs:
$13,338.64 - $12,000 = $1,338.64
According to this example, Jenny's termination cost will be $1,338.64.
Is it better to lease or buy a car? Whether you decide to buy or lease a car depends entirely on personal needs, financial position and how long the car will be used. Be sure to explore both options and make the decision that best meets your needs.
Learn more about vehicle finance options and calculate your monthly payments here.