Lease Vs. Purchase: The Great Automotive Debate

If you have purchased a vehicle in the past 15 years then you have probably looked at the different options available. Purchase, lease, or buy outright with cash. I say 15 years because leasing wasn’t nearly as popular pre-90’s as it is today, so most people only had two options. I thought it would be worth sharing a few thoughts on this popular debate and hopefully save some of you money in the future. Much of this debate is consumed in advantage/disadvantage myths. Frankly, its a very simple decision as to which is more financially prudent if you look closely at the numbers. Buy with cash. Unfortunately most people are not in a position to do this and yet they still want a new, or at least newer, vehicle. I won’t get into the behavior issues related to this today, so let’s just look at the numbers.

To Finance.

Let’s say your are interested in a brand new 2007 Honda Civic sedan. Base models with few options are going for about $17,500.00 plus taxes and other fees, so let’s make it an even $19,000 (probably a bit low). The lender will require around 10% down ($1,900.00) for a five year term (60 months) with an interest rate of 6.5%. If we plug this information into a loan calculator we find that the monthly payment would be around $335.00 per month. Over the life of the loan you will end up paying $2,974.87 in interest, for a grand total of $21,974.87 for this Honda Civic. The average car looses 60%, while many Honda’s are around 50%, during its first 5 years, meaning that while you have paid $21,974.87 for your Civic it will only be worth between $7,500-$10,000. Even with a value of $10,000 you have still lost $11,974.87

To Lease.

One of the great myths about leasing a vehicle is in theorized advantages. The thought is this, “if I lease my vehicle the down payment is less and the monthly payment is lower than if I financed a vehicle, therefore I will increase my monthly cash-flow”. Perhaps in the very short term this is true, but carried out over a typical 3-year lease period you will be paying much more than a traditionally financed vehicle, and here’s why.

Let’s say you lease that same brand new Honda Civic sedan (98% of leases are on new vehicles) that cost $17,500 for a three year (36 months) term, but will only be worth $10,500.00 (40% depreciation rate is average for the first 3 years of a new car). That is a loss of $7,000 of value to the dealership. The dealership then takes that $7,000 loss and stretches it our over a 36 month period giving you a monthly payment of $194.44. Not bad for a new Civic right? Well, you still have to add in interest (for the dealership profit), and if you don’t want any money down it is at least $75-125.00 higher per month. Add it all up and your payment is closer to $300.00. So take that $300 per month payment multiplied by the 36-month term and you end up paying $10,800.00 for your first 3 years. That’s $3,800.00 over the depreciated value of the Civic! And many cars have worst depreciation rates that equates to greater losses at your expense.

You’re not finished yet though. Now comes the time to return Civic to the dealership. The dealership will assess the condition of the vehicle to see if it has more than standard “wear and tear” and typically they will find something wrong with it. Then they check the mileage to see if you’ve exceeded the limits set in your lease. Every mile over the allotted amount will cost you between $.10 and $.25, and most leased vehicles go far beyond the lease amount as they normally only give between a 10,000-12,000 mile per year limit (while the average person drives 15,000 or more). We’ll go light and say you’ve haven’t exceeded the wear and tear conditions of your lease, and have only exceed your mileage limit by 1,500 miles. You would owe an additional $150-250.00 if you decide not to purchase the Civic at the leases termination.

If you do decide to purchase the Civic, the dealership will require you to pay the balance of the vehicles initial price, $10,500.00 in our case. Unless you have been saving for this, which 99.99% of people don’t, you’ll have to finance this amount..with interest of course. At the used car rate of around 7.5% with no additional money down, your newly financed Civic will cost you $326.62 per month with a three year (36 months) term. The interest on this over the three year term will cost you $1,258.15 for a grand total of $11,758.15.

So what did your leased 2007 Honda Civic sedan really cost you if everything went as stated above…$22,558.15! That is $5,058.15 over the asking price!

Summary.

Using the Civic above as our example, you would save $583.28 and own the car one year sooner by financing instead of leasing. But our example is also being very generous to the leaser, as most experience much higher costs than the ones allocated. Beyond financing or leasing, cash is easily the best method. Any person that can read can see that both financing and leasing results in losing thousands of dollars in interest and fees over the life of the loan. My advice…save for a car you can pay for with cash. Then start a saving account for the vehicle you really want while the interest is being accumulated on your behalf, not the lenders. Hopefully this was helpful.

What to do when you’re upside-down?

Here’s the scenario: you have a vehicle that you want to sell or trade-in for a different vehicle but you owe more than its worth (aka “upside down”). What do you do? For this scenario we will assume you have no extra cash to payoff the vehicle and there will be no additional cash towards a down payment beyond the licensing fees. Typically you will be more “upside down” the newer the loan is on the vehicle. If you purchased the vehicle on a 5-year term and you’re only 6-months into the loan, you will probably be much more upside down than if you waited until 2-years into the loan. So how do you determine when it’s better to take the hit by applying the difference between what you owe and what the vehicle is worth?

In the short run you rarely win by taking the hit. This is due to the fact that most people are trading up verses down. So people buy a more expensive car and transfer the amount owing onto a new car that will also go down in value. In the meantime the payments go up and loan terms get extended. Its a cycle that continues for years without end. So if the car in question is the only debt you have and you put all your extra money towards paying it off early, you should be out of debt and in a better position to get a new car (if you still want it) within a few years if not sooner.

In the long run you almost always win by taking the hit as long you follow the method I lay out. To illustrate this point here is a real life situation that one family faced. They owned two vehicles, owing $12,000 on a Dodge Caravan and $22,000 on a BMW. This family had a combined debt around $130,000 including these two vehicles. In an effort to reduce the overhead of the total debt I advised this family to sell both vehicles and downsize to vehicles that cost at least half as much. The problems came when they found that they were upside down on the van by $2,000 and the BMW by $6,000! Guys at one dealership wouldn’t even let them trade in BMW because it “wouldn’t be a smart move” by this family. That may have been true if they were only looking at the short-term impact, but if you look at the big picture it will blow away your thinking by how positive the impact would be even taking the dramatic hit, and here’s why. By trading the $22,000 BMW for a $7,000 car plus the $6,000 negative equity, they would end up with a $13,000 balance, and with $9,000 less overall debt. That debt reduction saves them 25 months worth of debt payments and almost $15,000 in total debt! Count’em 25…1,2,3,4…25! That means they are out of debt two years sooner and save $15,000 in the process. So you take a $6,000 hit and save 25 months and $15,000. Sounds like a smart plan to me. They would save even more by following that method with the van as well.

Auto dealers don’t see it this way because they are looking at the short-term impact and a lifestyle that says it’s normal to have a car payment your whole life. It’s part of their job to sell cars, so you shouldn’t expect them to give the financially prudent advice of not buying “brand new” cars that depreciate 30-40% the moment you drive them off the lot, and they definitely won’t tell you to buy only what you can afford. It will be buy only what you can “finance”. So next time you’re faced with the this decision I hope you consider the bigger picture in your equation.