To Buy or Lease Your New Car?

That is the question. The answer is math.

Note: This is the first of a 3-part series on buying versus leasing a new car. You’ll find a link to part 2 at the end of this article. Also, Abe Novy has written an article about the popular misconceptions of leasing that is an excellent preface to the series.

Suze Orman writes a column for O, The Oprah Magazine on personal finance, so presumably, she knows something that Oprah Winfrey’s readers don’t. Here’s what she says on her blog about leasing a new car:

Nearly 1/3 Of New Car Buyers Are Making A Very Big Mistake
November 25, 2016

I can’t be clearer: leasing is a horrible financial move. It is the auto industry’s way to get you to buy a car you can’t really afford. I don’t blame the auto financing folks, that’s their job. But it’s your job to make smart decisions with how you spend your money. And leasing is just a lousy deal.

The big problem is that when you lease there’s the temptation to keep leasing forever. So every three years-the standard lease length-you turn in your car and lease another. That means you are signing on for never-ending monthly car payments, all because you want a fresh new car every three years? C’mon.

Let’s keep this simple: Needs v. Wants. I get you may want a new car every three years, but do you need a new car every three years? Of course not. And don’t tell me you deserve a nice car. Please. You deserve financial security. You and your family deserve a lot more than a fancy car.

Please Please Don’t Lease

By contrast, Jessica Anderson at Kiplinger’s finance says that people have preconceived ideas about leasing she calls “myths”:

Five Myths on Leasing a Car
Learning the facts could save you a bundle.

By Jessica L. Anderson, Associate Editor

Leasing often gets a bad rap, and no wonder: Its confusing terms sound like fodder for a course in high finance, and dealers have been known to slip bad deals past confused car buyers who simply wanted low monthly payments.

About 30% of new-car transactions are leases, but I’m convinced that more people should be leasing.

Read more at Kiplinger’s Finance…

Which woman is right?

As it turns out, this is one of the most complicated financial decisions that most people will never choose to confront. Because the vast majority of buyers are ill-equipped to understand the vocabulary and the mathematics of car leasing, and the car dealership finance reps are no help because most of them don’t understand it, either.

In fact, Orman’s advice is baloney. She uses hyperbolic language like “horrible financial move” to sound more convincing, but she doesn’t bother to teach you how to think for yourself. There are two principal advantages to leasing that Orman overlooks:

  1. When you lease, you get an option to purchase the car at the end of the lease, for a price that is disclosed ahead of time and cannot be changed. This option is valuable. It reduces your risk that used car prices will drop, and it could save you thousands of dollars.
  2. In most states, you only pay taxes on the monthly lease payments, not on the entire purchase price.

Orman’s argument is that the lower monthly payments that come from leasing will somehow tempt you to buy a car that you can’t otherwise afford — i.e., that you won’t have the discipline to stay within your budget. She says she knows this, because back in 1987 she bought an expensive car she couldn’t afford to try and impress a man she was dating whom it turned out she didn’t really like that much anyway, and she thinks you’ll probably do that, too.

So… don’t.

I’ve put together a series of videos for those of you who are mathematically inclined or want to know more about cash flow diagrams and personal finance. If you’re calculator-savvy, you might enjoy these.

But if math isn’t your thing, then these four steps will help you understand whether you're getting a good lease deal.

  1. Choose the car first. Although I enjoy expensive cars, I don’t choose to own one. Back in 2010, when I was in the market for a new car, I chose a Honda Fit, because it had the lowest total cost of ownership (including fuel, maintenance, depreciation, and taxes). Kelley Blue Book has a service that allows you to track the least expensive vehicles on a total cost of ownership basis. When I want to drive a fancier car, like a Tesla Model X, or a Volvo XC90, or a Cadillac Escalade, I rent one from Turo. On the other hand, you (like Suze Orman) might be wondering whether my little Honda puts me at a disadvantage in the dating marketplace. It might. I worried about that a little bit until I realized that because I teach sustainability, I’d better own a small car. A big, fancy, expensive gas guzzler would just impress the wrong woman.
  2. Negotiate with your dealer until you agree on the value of the vehicle (i.e., the price). With some bargain-basement, nationally advertised lease deals, the Agreed Upon Value of the Vehicle is fixed by the manufacturer, not the dealer. There’s very little margin available for dealers selling these bare-bones cars, and they’ll attempt to upsell you to a model that has options that are more expensive than the advertised lease deal. That’s your decision. My point is that the value of the car to which you agree should be the same, whether you’re buying or leasing. Check that value for both options to ensure you’re comparing the same pricing in each case.
  3. Divide the Residual Value listed on your lease agreement by the Agreed Upon Value of the Vehicle to compute a percentage. We all know that new cars depreciate in value rapidly during the first three years of use. But how rapidly? The lease agreement will specify how much the car depreciates over the course of the lease, and that will be the biggest single expense in the calculation of your monthly payment. For a 3.5 year lease (42 months), the residual value will usually be somewhere around 55% of the value of the vehicle when it was new. But used car prices are volatile, like all markets, and the actual value of the car could be more or less. If your residual/new ratio is over 60%, then the leasing company is taking a big risk that used car prices will stay high. If that ratio is closer to 50%, then you are taking more risk. You want a lease deal with a very high residual ratio.
  4. Ask for the “money factor” used to compute the lease payments. Because you aren’t purchasing a car, and you don’t have a loan, when you lease, the dealer can’t use words like “price” or “interest rate”. But there is still a cost of financing, so the term of art in auto leasing is “money factor”. Some states require it to be disclosed, and others don’t. Multiple the money factor by 2400 and you’ll know the equivalent interest rate used in the monthly payment calculations. Then you can compare that to the interest rate in a loan quote. They can be very different. You want to find a lease deal that has a low money factor.

Leasing will always result in lower monthly payments than purchasing. In fact, if you chose to but the car at the end of the lease period, your monthly payments will go up. It’s important to know what you’re going to do with the monthly savings if you choose to lease your new car. When your answer is, “I will pay off high-interest credit cards or private student loan debt,” then leasing will be your best option. But when your answer for what to do with the savings is, “I will buy a more expensive car, or eat out more often, or pay down my low-interest rate home mortgage,” then purchasing your car is probably the better bet.

The second part of this series will help you understand the complicated language of your lease agreement, so you can compare the cost of financing your purchase with a lease to the cost of a loan.

However, those of you that have a sophisticated understanding of finance (like my engineering students do) may want to keep reading and watching here, because you appreciate the mathematical details.

Math Class

This four-part series of videos break down the choice of leasing versus buying a car using the tools of engineering finance. The first video begins drawing exemplary cash flow diagrams that allow comparison of the options like paying cash or financing.

Before you get too excited about equations and diagrams, be forewarned that the math in these videos isn’t for everyone. For example, the YouTube comments for Part 1 tend to go a lot like these:

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If you've got an appetite for this kind of thing, then Part 2 completes the cash flow diagram for the lease option and shows the equations necessary to compare the buying vs. leasing options on a net present value basis.

Parts 3 looks at a new car lease from the perspective of the leasing company and explains the risk that the leasing company accepts regarding the residual value in the lease agreement (or book value) and the market value of the used car at the end of the lease.

Finally, Part 4 compares the cost of buying with leasing a new car. It concludes that even in cases where leasing is more expensive, having the option to put the car back on the leasing company at the end of the lease term reduces risk, which may justify the increased expense.

In general, drivers with high discount rates (such as high-rate credit cards) will be better off leasing a vehicle for several years, even if they intend to buy it at the end of the lease term! This fact is often overlooked by personal finance “experts” that write advice on buying vs. leasing. This might be because the experts believe it is unlikely that someone with high-rate credit card debt will have the discipline to use the money saved on car payments to pay their debt down.

This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.

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Thomas P Seager, PhD

Written by Self-Actual Engineering @seagertp Join

Making of a Millionaire

Stories about money, personal finance and the path to financial independence.

Thomas P Seager, PhD

Written by Self-Actual Engineering @seagertp Join

Making of a Millionaire

Stories about money, personal finance and the path to financial independence.

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