For those who have never leased a car, leases can seem confusing, complicated and geared more toward business owners (who might deduct the expense) or individuals who simply can't afford car payments. But these perceptions may be outdated. Before eliminating leasing as a financing option, car buyers need a solid understanding of the different purchasing processes.
Buying: The Benefits
When you buy a car, the insurance limits on your policy are typically lower than if you lease. In addition, by owning a car, you're free to rack up the mileage without economic penalties or restrictions.
Buying: The Drawbacks
Presumably, as you pay down your car loan, you have the ability to build equity in the vehicle. Unfortunately, however, this is not always the case. When you purchase a car, your payments reflect the whole cost of the car, usually amortized over a four- to six-year period. But depreciation can take a nasty toll on the value of your car, especially in the first couple of years. As a result, buyers who put down modest down payments can end up financing a considerable portion of the car and even find themselves in an "upside-down situation", in which the car comes to be worth less than what the buyer stills owes on it at a given time.
Like the monthly payments of a mortgage, monthly car payments are divided between paying principal and interest, and the amounts dedicated to each vary from payment to payment. In the first years in which you pay back your car loan, the majority of each payment goes toward interest rather than principal. But in the first couple years after being purchased, most new vehicles depreciate 20-40%. The loss in equity is a double whammy: your car depreciates dramatically, and because the monthly payments you've been making have mostly gone toward interest rather than the principal, you are left with very little equity in the car.
Leasing: The Benefits
With a lease, you are essentially renting the car for a fixed number of months (typically 36-48 months). Therefore, you pay only for the use (depreciation) of the car for that period, and you are not forced to absorb the full depreciation cost of the vehicle. Leasing a car will never put you in an upside-down position.
Leasing also provides an alternative when buying a car is not an option. Most banks will not lend more than $30,000 for a car loan. If you are planning to acquire a car worth more than that, leasing may be your only option.
Finally, for business owners, leasing a car may offer tax advantages if the vehicle is used for business purposes.
Leasing: The Drawbacks
The mileage restrictions of leasing pose another drawback. If you drive a great deal during the year, consider instead a loan or an open-end lease (read below). Most leases restrict your mileage usage to 15,000 miles per year (sometimes even lower at 12,000 per year). If you go over your allotted miles, you pay extra: the going rate is about 15 cents for every mile over your limit, and 20-25 cents for luxury cars. So, if you go over your limit by 4,000 miles, you can expect to pay about $800 at the end of the lease.
Finally, insurers usually charge higher coverage costs for leased vehicles. However, depending on your age, driving record and place of residence, that additional cost may be nominal.
Car Leasing: Words of Caution
When leasing, it's important to consider a vehicle that best retains its value and rethink cars with a high depreciation rate. Devious dealers try to shift more of the depreciation cost onto you by embedding an unfairly low residual value.
Also, when entering a lease agreement, be aware of any clauses in the contract regarding additional charges for "excess wear and tear" or above-average costs for additional mileage. You want to minimize any surprise costs as much as possible.
With an open-end lease (also known as an equity lease), you must purchase the car at the end of the lease period for a predetermined amount. This is often the type of lease used by businesses or individuals who drive a lot. Most consumer groups suggest that the closed-end lease is the best option, because it poses less risk upon the expiration of the lease term.
Educating yourself about the two financing options will give you the confidence you need when you step into a dealer's showroom. However, please remember whether you are buying or leasing, remain within your means. A car is a car and it should be safe, practical and fuel efficient. Do not over spend, especially if you are living on a limited budget. There are no long-term returns on your investment in a car, unlike buying a piece of property, which in all likelihood will appreciate over time.