Should You Lease or Finance Your Next Car?

Should You Lease or Finance Your Next Car?

Leasing or Financing?  That is sometimes not such an easy question.  Your choice to lease or finance depends on many factors like what you can afford, how long you want to own the vehicle, what you are using the vehicle for, and many other factors.  Your choice to lease the vehicle should never be just on monthly payments alone.  

To bypass all the confusion is to pay cash of course. However, we cannot all afford to pay cash for a vehicle which leaves us two primary options: 

  1. Finance the balance of the vehicle after down payment and other fees or; 
  2. Lease the vehicle.  

What is the difference?  Does it matter? Does leasing get you a better deal than financing?  Let’s take an in-depth look at the differences to help you make the right choice between the two common methods of buying a car.

Lease Vs. Finance Comparison Table

Here is a quick comparison table you can use for the primary differences between leasing and financing:

Leasing a VehicleFinancing a Vehicle
Term12-60 months12-72 months
Down PaymentsSet by the lender: reduces cap costSet by the lender: reduces the purchase price or pays for other fees 
Monthly PaymentsPays for depreciation plus lease factor (interest)Reduces Principle and pays for interest expense
Payment Rate FactorsLease factorInterest rate
End of ContractReturn vehicle, pay any fees or purchase vehicle based on the residual value + fees.Own vehicle
Cost of FinancingLease factor, down payment, lease-end fees, mileage costs, excess wear, and more.Interest fees

What is the difference between leasing and financing?

Definition of Leasing:
Vehicle leasing
 is the leasing (or the use) of a motor vehicle for a fixed period of time at an agreed amount of money for the lease. … The key difference in a lease is that after the primary term (usually 2, 3 or 4 years) the vehicle has to either be returned to the leasing company or purchased for the residual value.

Definition of Financing:
Auto financing, also known as car financecar financing or auto finance, refers to the range of financial products available that allow people to acquire a car with any arrangement other than a full-cash single lump payment (outright payment). … Auto financing refers to borrowing money to buy a car.

Definitions Courtesy of Investopedia

The primary difference between leasing a car and financing a car is what happens at the end of each term. In a lease, the car has a residual value that the buyer must either pay or return the car. In fiancing, at the end of the term, you own the car.

In a lease, because you return the car at some assumed value, your monthly payments are lower than traditional financing.  Basically, the bank has given you a pre-arranged value of the vehicle at the end of the term of the lease.

Understanding Leasing (The Basics)

Leasing Definitions:

Capitalized Cost: This is basically the cost of the car.  When you are negotiating the cost of the car, in a lease the down payment can also be called a cap cost reduction.  Always negotiate the price of the care before you negotiate the lease.

Cap Cost Reduction: This can be a down payment, trade-in value, rebates, or any other amount that reduces the capitalized cost.

Lease Factore (money factor): The lease factor is similar to an interest rate.  It is the amount the bank charges you on the cap cost (after reductions) + residual multiplied by the lease factor for the term of the lease.  The big difference between the lease factor and interest rate for financing is the way the interest is calculated. In financing, it is based on the monthly balance and reduces over the time of the loan.  In a lease, it is fixed over the term. In other words, you are going to pay more in “interest” with a lease vs. financing. In addition, you will always pay all the interest in a lease no matter when you purchase or exit the contract.  In financing, if you pay the vehicle off early, you save on the amount of interest you 

Residual: This is the estimated value of the car at the end of the lease.  A good estimate of what the residual is going to be is to simply look at the same model vehicle that is the age of the term of the lease.  For example, if you are buying a new honda civic on a 36-month lease, look up the value of that same car with the number of miles you are allowed in the lease.  This will give you a good idea of what the residual looks like and what the depreciation of the car is going to be.

Depreciation: This is the amount of value the vehicle loses over the time of the lease based on the miles allotted.  The more value that is lost, the more the lease payment is going to be. Since you are basically renting the car, the bank has the liability to sell the car once you give it back.  Your monthly payments pay for the depreciation plus interest over the lease period.

This is important to understand!  Leasing is paying for the amount the car is going to lose value over the term of the lease contract.  If you have buy a vehicle that does not hold its value, your lease payment is going to be higher than the same price of a vehicle that holds value!  

Leasing is basically renting the vehicle based on how much the bank thinks the vehicle will lose value over the term of the lease plus interest (lease factor) plus taxes. 

For example, if you lease a vehicle valued at $30K over a 24-month term, the bank will determine what that vehicle is worth after 24 months, add interest, and then divide that amount by 24 (not quite that simple but you get the idea). 

In our example, if the bank thinks the vehicle will be worth 20K after 24 months, then the majority of your payment will be the 10K loss in value plus interest and taxes.

In other words, the primary factor in determining how much your lease payment will be is the difference in value between the price you paid now and the value of the vehicle at the lease-end.  This is a place where banks can add strange terms like 39-months to pad their exposure and make a worse deal for the consumer.  Never by an odd term lease.

Since it is hard to get the published residual values and current lease factors, leasing can be very easy for consumers to get a less than good deal.  Amounts can be hidden any number of places and unless you understand all components you can really get a bad deal.

Let me illustrate, part of the allure to leasing is the low monthly payments.  The payments are always lower than financing since depreciation will always be less than the full value of the vehicle.  That is the first trap since it is easy to ask a consumer what they can afford and tailor any lease payment to fit that request even though the payments could be lower.  For example, a typical vehicle will depreciate 30-40% of its value after 36 months, if your lease payments total more than that in 36-months you are getting a bad deal.

On a popular lease trading site, I saw a 2013 Ford Flex SE (base model) 39-month (note odd term) lease for $619 per month.  At $619 per month, the total payments are $24K, not including any money the person put down, for a $28K vehicle.  Basically the bank will get the vehicle back that is nearly paid off and turn around and sell it for $15-18K.  This person overpaid by at least $10K (probably more).   That dealer should be run out of business.

Leasing: How it can be complicated

Let’s look at a table comparison showing how complicated a lease can be.

Here is an add for a GMC Yukon:

Here is the first thing you should note, the price of the Yukon is not disclosed in either offer.  For the purchase, we are lucky and know enough information that we can calculate what they are selling the Yukon for.

-Term 84 months: $49,476 + $8,499 down payment = $57,975 Total Cost.  The $49K includes an interest rate of 5.04% over the term.  

Using a financial payment calculator, we can determine the price of the Yukon.  

Selling price in the Yukon Financing offer is approximately $50,150

Now back to the lease.  Unfortunately for the lease, we are missing two key pieces of information.

-The lease factor (almost never disclosed until negotiating)
-The residual (almost never disclosed until negotiating)

Since the two pieces of information are not disclosed we don’t have enough information to really understand if the lease is good or not.  In that case, we can make some assumptions and see how the payment compares to a good deal.

First assumption:
Let’s make this a 0% offer as that would be the best case.    

Second assumption:
Let’s give the Yukon a generous residual value based on 30% depreciation.

So, with that the lease payment would be:
$50,150 X .3 (30% depreciation) = $15,045 – $7,499 (down payment) = $7,546 / 36 = $209.61 per month before taxes and fees.

Or just use this auto lease payment calculator to get the same answer!

Ok, now let’s adjust the lease factor (money factor) to get us up to the advertised price assuming the generous depreciation.

To get to the monthly payment of $349 we adjust the money factor to be equivalent to a 4.3% interest rate using the auto lease calculator.

Yukon Lease ExampleYukon Lease Low ResidualYukon Lease High ResidualYukon Financing 84 months
Interest Rate0%0%4.3%5.04%
Interest Cost$0.00$0.00$5,015$7,864
Residual Value$35,105$30,090$35,105$0
Total Cost$50,150 +fees$50,150+fees$55,165 + fees$58,014

Here is what makes leasing so difficult.  Your payment is a function of three things, your cap cost reduction (down payment), the lease (money) factor, and the residual value.  As you can see in the table above, two examples yield the same lease payment but have very different total costs. 

Something else to consider, the interest you pay in a lease is much different than the interest you pay in a purchase.  Why? It is the way the bank calculates your payments. We went over the basic example above assuming no interest, when you add that component the bank calculates a fixed interest payment based on the Cap Cost (cost of the vehicle – down payments/rebates/trade-in) plus the residual value.  

Wow, that adds up.  Not only that, it is fixed for the entire term, unlike traditional financing where the interest you pay is reduced each month as you pay the car down.  So, in the example lease with 4.3% interest, the total interest paid is $5,015, if you were to finance the car, the total interest at the same interest rate would be $2,886.  Quite a large difference.  

Here is how the interest part of the lease is calculated using our example:

Interest Rate: 4.3% converted to a lease factor (4.3/2400) = .0017917 (lease factor)

To get the monthly interest payment:

.0017917 X ($35,105 (residual) + $42,651 (cap cost)) = $139.31

Now multiply that by the term of 36 months to get $5,015.

Understanding Financing (The Basics)

Financing is much more simple and harder to hide fees in a deal.  Financing is simply financing the final value of the vehicle after your down payment (and incentives) has been applied plus taxes and interest.

If you are financing your vehicle, unlike leasing, you can easily calculate what your payment should be based on the price you agree to pay for the vehicle less any cash or incentives applied.  On this site, you can print out tables that calculate the payment or there are hundreds of web apps you can find to take with you to the dealer.  Either way, it is very clear how the numbers are calculated.  The only way the dealer can add expense is to either give you a higher interest rate than what you qualify for, add extra items like road vehicle insurance, or not apply incentives into the agreed-upon price.

Does it matter?

Unfortunately, for most people leasing does not make sense but is consistently pushed due to the lower per month payments.  Leasing has a lot of downsides including more places to hide expenses, it is harder to calculate what your costs should be, you never own your vehicle unless you buy out the lease, residual values are not widely published, down payments are often lost in the formula, lease factors are hard to compare, mileage limits are placed in the contract, and fees are often added to the end of the lease if you do want to purchase the vehicle.

So with so many downsides why do people lease?  Well, if you fully understand all the numbers you can sometimes get a better deal leasing then financing, but it is very hard to know for sure.  Leasing also makes sense if you are a person that can afford to switch vehicles every two, three, or four years.  Some people just don’t want to own a vehicle beyond four years so leasing is an option for them.  However, if you keep leasing you will never have anything to show for the hard money you spend every month.

In summary, if you are in the market for a new vehicle, pay cash or finance.  Very few people have a need to lease and should avoid them.  Remember, you will never own or have any equity in a leased vehicle.  All the cash you pay is paying down the amount the vehicle is expected to lose value, buy its very definition it does not build any value.

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