When considering a new car, you typically have three options: buying it with cash, buying it through a loan (financing), or leasing it. For those in the US, the decision typically comes down to buying or leasing.
The differences between buying and leasing a car seem straightforward. Leasing a car often means that you have access to a new car every few years. Buying a car often means that you intend to drive the same car for a much longer period. Leasing may limit your mileage and ability to customize. When you buy, on the other hand, you have no contractual limitations on your mileage or limitations to customize your car as you wish.
You might assume that buying a car is cheaper and more practical than leasing. But if this were so, the monthly lease payments for a vehicle would not be a great deal lower—about 40 percent lower—than monthly loan payments for the same vehicle.
Whether buying or leasing is better often comes down to your budget, lifestyle, preferences, expected mileage, and how long you plan to keep the car. Which choice is more practical for you may not be the same choice that is more practical for your friend.
Today, we review the differences between buying and leasing so that you can make the most informed decision possible the next time you make this choice.
How Does Leasing a Car Work?
To lease a car is to rent it—not own it. But leasing a car feels like owning it, and leasing is still a popular way to finance a car. In the first quarter of 2020, about 30 percent of all new vehicles in the US were leased. If you are thinking about leasing your first car, you should know exactly how leasing works.
A car lease is an agreement between the owner of the vehicle, the lessor, and the person who is borrowing the car, the lessee. The agreement specifies for how long you will be driving the car and how many miles you can drive before incurring an extra cost. The lease also specifies the base amount that the lessee must pay each month.
How much it will cost you to lease is an important consideration. And this brings us to the subject of depreciation, the main factor that makes a monthly lease payment for a car cheaper than a monthly payment on a loan to buy the car.
Depreciation—decline in estimated value—affects the long-term value of a car and the total cost of owning it. A car’s value starts to decrease as soon as it leaves the dealer’s lot. On average, a brand-new car depreciates about 20 percent in the first year of a lease and 10 percent every year thereafter.
The financial aspect of the lease is structured so that what you pay takes into account the amount of depreciation. Different cars have different rates of depreciation. Before you approach a dealer, you can use an online car depreciation calculator to estimate how the car you are interested in will decline in value.
Understanding the following terms will help you understand the cost of the lease.
- Capitalized cost is the current total price of the car being financed by the lease. This total price includes any taxes, fees, and add-ons that are also being financed.
- Residual value is what your car will be worth when the lease ends.
- The money factor is the basis of the interest rate you will pay. If your dealer quotes a money factor of 0.00125, multiply this factor by 2,000 to obtain the corresponding annual percentage rate (APR): 2.5%. An online money-factor calculator will help you crunch the numbers.
- Drive-off costs are the down payment plus any up-front fees that you must pay before you can leave the lot with the car. These may include DMV fees and leasing fees as a security deposit.
The cost of leasing a car is the capitalized cost minus the residual value plus interest and fees. If the capitalized cost is $30,000 and the residual value after five years is $20,000, over the course of those five years you must pay $10,000 plus interest and fees. The capitalization cost determines the amount of your lease payment, so always negotiate for a lower capitalization cost before indicating your intention to lease.
A lease agreement also includes provisions to help preserve the value of the car. Your dealer wants its value to be as high as possible when you return it at the end of the lease.
- Restricted use. Some leases won’t let you use your car to drive for a ridesharing service or won’t let you take it out of the country without permission.
- Mileage limits. A typical lease allows you to drive up to 12,000 miles a year. If you drive more than that, you must pay mileage penalties that start at about 15 cents per mile but can be as high as twice that. You can negotiate higher mileage limits if you are willing to pay a higher up-front cost.
- Wear-and-tear limits. You cannot drive a car for three years without having the car undergo at least minor deterioration. But dealers will charge you for some types of damage or for an amount of wear and tear that they deem excessive.
Leasing a car has unique implications for taxes, insurance, fees—which vary from state to state—and other costs.
What Are the Benefits of Leasing a Vehicle?
- Getting a new car. When you lease a car, there’s a good chance that you’ll get a brand-new car with the latest technology and providing top-notch performance, making your driving experience more comfortable and enjoyable.
- Lower monthly lease payments. Leasing a car typically means monthly payments that are lower than the payments on a car loan for the same car. Leasing may thus enable you to drive a car that you could not have afforded otherwise.
- Minimal or no maintenance expenses. Most lease contracts include a warranty that covers most of your repair and maintenance expenses. You normally won’t have to spend a lot of money on repair or maintenance.
- Greater flexibility. If you like the idea of driving a new car every few years or you are anticipating a change in lifestyle, a lease provides the flexibility you need.
What Are the Disadvantages of Leasing a Vehicle?
- Greater long-term cost. One downside of leasing a car is that you always have a monthly payment to make. Sure, lease payments are cheaper in the short run, but they’ll add up to more money in the long run. As long as you keep leasing a new set of wheels every few years, the payments never end.
- Mileage limits. A lease agreement limits the number of miles you can drive each year. Most leases quote mileage limits of 12,000 miles to 15,000 miles a year. Exceeding your mileage limit will incur a penalty of 15 cents or more per mile.
- Termination penalties. You will probably have to pay a penalty if you end your lease before the termination date stipulated in the lease agreement.
- Damage costs. You must pay additional fees if you return the car with cracks, dents, and other excessive wear and tear.
How Does Financing a Car Work?
To finance a car means to take out a loan through a financial institution to buy the car. These institutions may include banks, online lenders, credit unions, and even some car dealerships. In exchange for the money, you must make consistent monthly payments that include interest over a specified period of time.
Usually, you won’t borrow an amount equal to the full price of the car you want to buy. You will first make a down payment of 10 percent to 20 percent of the purchasing price, then borrow to pay for the remainder of the cost. If you’re buying a car for $30,000, you must put down $3,000 to $6,000. Putting down as much money as you can afford is always a good idea, since it will reduce how much you need to borrow and pay interest on. Being able to borrow less also means a lower monthly payment.
Lenders won’t approve your loan application outright. They will first check your credit score. The better your score, the more likely it is that you will be approved, and the better your options will be. Lenders also consider the loan amount, the length of loan, your debt-to-income ratio, and the age of the vehicle when considering your loan application.
If your loan is approved, you must make monthly payments until the entire loan is paid off. Each monthly payment includes a principal payment and an interest payment. The principal payment reduces your loan balance and the interest payment covers the interest due.
Once you have fully repaid the loan, your lender will send a lien-release document to the state transportation agency so that the title of the car can be updated and transferred to you.
What Are the Benefits of Financing a Vehicle?
- Ownership. When you finance a car, it’s all yours once you’ve paid the loan in full. You don’t have to worry about recurring payments or returning the car to a dealer.
- Unlimited mileage. Financing a car through an auto loan doesn’t entail the mileage limits that are standard when you lease a car. You can drive as often as you want.
- Customization options. Your lender won’t impose any restrictions on customizing your new vehicle. You can alter the exterior or interior just as you please.
- Ability to sell your car or trade it in. If you pay off the loan and no longer want the car, you can sell it or trade it in for a new one.
What Are the Disadvantages of Financing a Vehicle?
- Higher monthly payments. Depending on the make, model, and year of manufacture of the car, your monthly payments may be much higher than the monthly payments required to lease the same car. Even financing a used car may be very expensive.
- Necessity of a down payment. Most dealers require a down payment on a new car, the amount of which may be much more than the up-front costs you would pay for leasing the same car.
- Necessity of paying costs out of pocket. If your car needs maintenance service or it breaks down, you must pay for these costs out of your own pocket. By contrast, lease agreements extend warranties to your vehicle.
- Depreciation. Your car starts losing value as soon it leaves the dealer’s lot. Cars with a high rate of depreciation may not be worth very much by the time you pay off the loan.
Leasing Versus Financing: How It Affects Your Insurance
Whether you lease a car or finance it won’t affect the cost of your car insurance. Usually, the amount of your insurance premiums depends on considerations like the make and model of the vehicle, your driving history, and the number of your traffic infractions. Your insurance provider also needs to know how you’re paying for the vehicle, since the lender must be included in your insurance policy.
Both leasing and financing your vehicle may affect the kind of insurance you need to carry. A lender may mandate specific insurance coverage for your car. For instance, a lending institution will seek to protect its financial interest in your car by requiring you to carry collision and comprehensive coverage in addition to the minimum liability coverage required by your state.
Your lessor may also include gap insurance in your monthly lease payments. Gap insurance helps pay off your lease if a balance remains and the car you’re leasing is totaled, the cost of repairing the car exceeding its value.
When you finance a car, you are required to carry liability insurance. Depending on what state you live in, you may also be required to carry personal injury coverage and uninsured/underinsured motorist coverage. You will be able to adjust these coverages on your policy once you pay off the loan.
Frequently Asked Questions
What credit score do I need in order to lease a car?
Your credit score affects the kind of car you can get and how much you pay when you lease it. According to Experian, the average credit score for a car lease in 2020 was 729. You can still lease a car if you have a bad credit score, though this may be an uphill battle. A bad score will also attract a higher interest rate on your lease.
Does leasing a car affect your credit score?
Leasing a car has the same effect on your credit score as taking out a car loan. Your credit score takes a hit if you miss payments or default on your lease. On the other hand, consistent monthly lease payments can strengthen your credit score, since lease payments are reported like other loan payments.
Is leasing a car a waste of money?
To lease a car is to pay to drive it for a specific part of its life. Leasing a car is not a waste of money insofar as it gives you an economical means of driving a new vehicle. Although you cannot own the asset solely by leasing it, leasing usually enables you to drive a new car at a monthly cost that is a fraction of the monthly payment for a car loan.
Do lease payments go towards purchase?
Your lease payments pay only for your use of the car. If you really like the car and want to buy it, you’ll need to take out a loan. Lease payments cannot be used to offset the cost of a down payment or any principal. But if you decide to buy the car at the end of the lease, you will pay the price for the now-depreciated value of the car, not the original price of the car.