After buying a home, buying a car is one of the biggest purchases most people make in their lives. And whether you lease or finance your car can significantly affect how much you end up paying for it.
Unless you can afford to pay for the entire cost of your car upfront (and let’s be honest, most of us don’t have $25,000–$50,000 tucked away under our mattress), you have two options: leasing and financing.
The difference between leasing and financing
With both leasing and financing, you buy the car from the dealership and borrow money from it to fund the transaction. In exchange, you make monthly payments to pay back the loan with interest. (There’s always a catch, right?)
However, when you lease a car, you also agree to sell the car back to the dealership at the end of the lease for a pre-specified price (which is called the residual price). So even though you’re technically borrowing the money needed for the full price of the car (and paying interest on this amount), your monthly payments are lower. Why? Because all you need to pay back is the money you owe above the residual price. Of course, at the end of the lease, you can also choose not to give the car back to the dealership. In this case, you would pay off the remaining balance of the loan, which is the residual price.
Leasing vs. financing: An example
That was a bit of an abstract explanation. So let’s look at an example to break down all the finance lingo. Imagine that you’re buying a new 2018 Honda Civic, and after choosing your packages and negotiating with the salesperson, the price comes out to $30,000. To simplify things, let’s assume the finance interest rate and lease interest rate are both 0%.
In real life, you’d have multiple options for the length of your contract.
But for the sake of this example, let’s assume you’re comparing two options: a 5-year (60-month) finance or a 3-year (36-month) lease. Before we can start crunching numbers, we need one more piece of information: the 3-year residual price (the estimated cost of the car at the end of your lease). Let’s assume the car is expected to lose 40% of its value over 3 years, so we’ll set the residual price to $18,000.
Now it’s time to put it all together.
(Hate math? Don’t worry—we’ll do all the heavy lifting here.)
For the 5-year finance option, you’ll have to make 60 monthly payments of $500 to pay off the car ($30,000/60 = $500). For the 3-year lease option, you’ll have to make 36 monthly payments of $333 to pay off the cost of the car up to the residual amount ($30,000 - $18,000 = $12,000 and $12,000/36 = $333).
Even if numbers make you anxious, it’s easy to see that a $500 monthly payment is much more than a $300 monthly payment. But comparing leasing to financing isn’t just about looking at the monthly payment costs. (If only it were that easy). To figure out which option is better, we need to look at what might happen at the end of the 3 years.
Let’s say you plan on driving the car for only 3 years. We’ll look at two potential outcomes:
Outcome #1: Your car retains more value than expected
After 3 years, your car retains more of its value than was expected. (Maybe you didn’t drive it much or the model turned out to be very popular and in high demand). As a result, the car has a trade-in value of $20,000 (not the $18,000 that was expected). If you leased the car, you have the option to pay off the remaining $18,000 balance and keep the car. Because the car is worth $20,000, you would pay off the $18,000 and sell the car (or trade it in for a new one) for $20,000. The total cost of the car over the 3 years is $10,000 ($333*36 + $18,000 - $20,000).
If you financed the car and don’t want it after 3 years, you can pay off the remaining 2 years of monthly payments and then sell the car for the same $20,000. The total cost of the car over the 3 years would also be $10,000 ($500*36 + $500*24 - $20,000).
So to summarize, if your car retains more value than expected, there’s no difference between the two options.
Outcome #2: Your car retains less value than expected
After 3 years, your car retains less of its value than was expected. (Maybe the car was in an accident or it turned out to be unpopular and in low demand). As a result, the car has a trade-in value of $15,000 (not the $18,000 that was expected). If you leased the car, you would walk away from the deal and the total cost of the car over the 3 years would be $12,000 ($333 * 36).
If you financed the car, you don’t have the option to walk away. So if you don’t want the car after 3 years, you’d have to pay off the remaining 2 years of monthly payments and then sell the car for $15,000. The total cost of the car over the 3 years would be $15,000 ($500*36 + $500*24 - $15,000).
In sum, if your car retains less value than expected, financing could end up being significantly more money than leasing. In this example, the $3000 difference is enough to fund a small vacation or cover the cost of your gym membership for several years.
Why leasing is usually the better option
So should you lease or finance your car? Leasing a car is almost always better than financing it. The only other factor that might influence your decision is the interest rate available. Sometimes, car manufacturers charge different interest rates for leasing vs. financing. So even though leasing gives you the option to sell your car back at the residual price, it may not be worth it if you have to pay a higher interest rate.
But if the interest rates aren’t all that different, leasing your car is the way to go.
Remember: Always get an estimate for the trade-in value of your vehicle
Just make sure that when you’re near the end of your lease term, you get an estimate for the trade-in value of your vehicle. You can do this easily by looking up the wholesale value online or visiting a different dealership to have your car appraised. Compare the value against the residual price to determine whether it makes more sense to pay off the balance of your loan and keep the car or give it back and start fresh.
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