Leasing versus buying

In short

A friend of mine once signed a lease because the monthly payment looked so small. He was proud of it for about a year. If you are weighing a lease against a purchase, the first thing to know is that the two paths answer different questions. A lease is paying for the part of the car you use up. A purchase is paying for the whole car. Before you sign anything, ask the dealer for the total of every payment over the full term, plus every fee due at signing and at the end. Then compare that figure to the total cost of buying, after you subtract what the car could sell for later. Put your yearly mileage on paper first, because it decides more than any other number.

The whole of it

What it is

I once watched a neighbor of mine stand in a dealership for three hours because nobody had explained the difference to him in plain words. So let me try, the way I would on a porch. When you buy a car, you pay for all of it, either in cash or with a loan, and when you finish paying, it is yours. You can drive it ten years or sell it next spring. When you lease, you rent the car for a set time, often two or three years. You pay for the drop in its value during that time, plus a charge for the money tied up, plus some fees. At the end, you give it back.

You are a careful person, or you would not be reading this. So notice what each path really gives you. Leasing gives you a newer car and a lower monthly payment. Buying gives you something you own. Neither one is wrong. Each one just fits a different life.

How it works

If you are holding a lease quote right now, you will see a few terms that sound strange. The capitalized cost is the price the lease starts from, and it can be negotiated, just like a purchase price. The residual value is what the leasing company thinks the car will be worth when the lease ends. Your payments cover the gap between those two numbers. The money factor is the lease version of interest. It is written as a small decimal, and if you multiply it by 2,400, you get a rough yearly interest rate. That trick lets you compare it to a loan.

Here is the simple math behind a monthly lease payment. Take the capitalized cost and subtract the residual value. Divide that gap by the number of months. That is the depreciation part, meaning the loss in value. Then add the capitalized cost and the residual value together, and multiply by the money factor. That is the rent charge part. Add the two parts, and you have the base payment before tax.

A loan works in a more familiar way. You borrow the price, less any down payment, and repay it with interest over a fixed number of months. Each payment builds ownership. At the end, the car is yours, and the payments stop.

Now the catch with leasing. Most leases set a yearly mileage limit. Go over it, and you pay a fee for every extra mile. You also owe for damage beyond normal wear. And if you want out early, the penalty can be steep. Read those pages of the contract. I know they are dull. Read them anyway.

The numbers, and where to find yours

You have probably noticed that the ads show one bright monthly figure and bury the rest. Your job is to dig up the quiet numbers. On a lease, find the capitalized cost, the residual value, the money factor, the term in months, the mileage limit, the fee per extra mile, the money due at signing, and the fee at lease end. Ask for them in writing. Federal rules under the Consumer Leasing Act, carried out through the Federal Reserve's Regulation M, require lessors to disclose key lease terms before you sign. That is why the paperwork should list them.

On a loan, find the price of the car, your down payment, the interest rate, the loan term, and any fees added to the loan. Federal rules under the Truth in Lending Act require the lender to show you the annual percentage rate and the finance charge. The Federal Trade Commission has plain language guides on both leasing and financing cars at consumer.ftc.gov, and they are worth a few minutes.

Some numbers change by year and by state. Sales tax on a lease can be charged on the payments or on the full price, depending on where you live. Registration fees vary too. The federal electric vehicle tax credit has rules that have changed before, and the IRS explains the current rules at IRS.gov. The credit may apply differently to a lease than to a purchase. Your state revenue office can tell you how your own state taxes each choice. The federal credit for a qualifying electric vehicle is currently the current figure, which the official source publishes each year.

A worked example

Consider a woman named Marisol. She is looking at a car with a price of 30,000 dollars. She plans to keep it about six years and drives 12,000 miles a year.

First, the lease. Say the capitalized cost is 30,000 dollars, the residual value is 18,000 dollars, the term is 36 months, and the money factor is 0.0025. The depreciation part is 30,000 minus 18,000, which is 12,000. Divide by 36 months, and you get 333.33 dollars a month. The rent charge part is 30,000 plus 18,000, which is 48,000. Multiply by 0.0025, and you get 120 dollars a month. The base payment is 333.33 plus 120, which is 453.33 dollars a month before tax. Over 36 months, that totals 16,320 dollars. Add 2,000 dollars due at signing, and the three year cost is 18,320 dollars. She owns nothing at the end. If she wants a car after that, she leases again or buys.

Now the purchase. She puts 3,000 dollars down and borrows 27,000 dollars for 60 months at 6 percent. That gives a payment of about 522 dollars a month. Over 60 months, that totals 31,320 dollars. Add the 3,000 down payment, and she has spent 34,320 dollars over five years. If the car is then worth 12,000 dollars, her net cost is 34,320 minus 12,000, which is 22,320 dollars. She also owns a car she can keep driving with no payment at all.

Compare the two over six years, since she plans to keep a car that long. Suppose she leases one car for three years and a second, on the same terms, for three more. That is 18,320 plus 18,320, which comes to 36,640 dollars, and she owns nothing at the end. Now suppose she buys and keeps the car all six years. Her spending so far is the 34,320 dollars, and she still holds a car that has some value. Notice that the monthly lease payment was lower. Notice too that the six year total was higher. That is the piece the bright ad leaves out.

Where it goes wrong

I have seen good people trip on this, and it is never because they were foolish. It is because the monthly number was so tempting. The first slip is driving more than the mileage limit. Every extra mile costs money, and it adds up fast. Do the mileage math before you sign. The second slip is treating a lease like a way to get a nicer car for less money. It lowers the payment. It does not lower the true cost, since you pay for the drop in value either way.

The third slip is leaving a lease early. Breaking one can cost you most of what remains, so treat the term as a promise. The fourth is buying with a long loan and a small down payment. Then you may owe more than the car is worth, which can make it hard to sell without paying the gap out of pocket. The fifth is skipping the fees. Signing fees, lease end fees, and loan fees all belong in your total.

One more thing, and I say it gently. Take your time with this. The papers will read the same tomorrow, and you can carry them home.

Questions to answer before you leave this page

How many miles do you truly drive in a year, and did you check it against the mileage limit in the lease? Do you want to be done with payments someday, or would you rather always have a newer car? Have you added up every payment and every fee over the whole term, for both the lease and the purchase? Could you handle a repair bill on an older car, or does a warranty give you more peace of mind? What does your state charge in tax and fees for each choice, and did you check the source yourself? And if your plans changed in two years, which path would leave you in the better spot?