Lease or buy?
It’s a common question. Many people understand buying a car.
You negotiate the sale price, pay cash or finance the car, and you are on your way. At the end of the financing, you own the car.
Fewer people understand leasing a car.
You get more jargon and ways to hide the cost: money factor, residual value, mileage allowance, and more.
Let’s look at how leasing a car works, rules of thumb, advantages of leasing a car, and disadvantages of leasing a car to help you answer, “Should I buy or lease a car?”.
How Leasing a Car Works
The first thing to understand is that with leasing a car, you are renting.
You don’t own the car at the end of the term. For example, if you agree to lease it for 36 months, you can return the car or buy it from the dealership at the end of the agreement.
While you are not directly taking out a loan to lease the vehicle, that’s essentially what is happening in the background, and there is an interest rate embedded in the calculations.
That’s important to understand because many people may think they are paying no interest, but you are – it’s just not in a big, bold font like when you buy a car.
Your payments for a lease are based on:
- Sale price/capitalized cost
- Length of lease
- Financing/money factor/rent or lease charge
- Residual value
- Mileage allowance
- Taxes and fees
The sale price is called the capitalized cost or “cap cost.” As with buying a car, the capitalized cost is negotiable. You don’t need to accept the first price they tell you. The lower the capitalized cost, the lower your monthly payment.
Length of Lease
The length of the lease is often 24-36 months. One way a dealership might make the car more affordable is by extending the lease out a few months. For example, if a 24-month lease doesn’t work in your budget, they may suggest a 30-month lease. Keep in mind many warranties end at 36 months, so if you go longer than 36 months, you are exposing yourself to more risk when the car needs repairs.
Financing/Money Factor/Rent or Lease charge
Leases have financing embedded in them, but it’s often hidden. The financing portion is often called the “rent or lease charge” or “money factor”.
To calculate your annual percentage rate (APR) to put it in similar terms of buying, multiply the money factor by 2,400. For instance, if the money factor is 0.00115, the APR would be 2.76% (0.00115 x 2,400).
The money factor won’t be on the lease terms. It’s mostly determined by your credit score. The lower the money factor, the lower your monthly payment. You can either ask the dealership to provide it or calculate it yourself. To calculate the money factor, follow the formula below:
Money Factor = Sum of Rent or Lease Charge / (Cap Cost + Residual Value) * Lease Term
We’ll look at an in-depth example later.
The residual value is also very important because it’s the agreed-upon value of the vehicle at the end of the lease. If you want to buy the car at the end of the lease, the residual value is what you will pay. While the residual value is usually not negotiable, you may be able to negotiate the buy-out price separately to a value lower than the residual value.
Sometimes they will state the specific value, and other times, they will express it as a percentage.
For a 36-month lease, most cars have a residual value between 45% and 65%. You can use that as a rough benchmark.
For example, if the capitalized cost was $30,000 with a 60% residual, the residual value, or the amount you would pay at the end of the lease if you want to buy the car would be $18,000 ($30,000 x 0.60).
The mileage allowance will also determine your price. Many leases allow you to drive 12,000 miles without paying additional fees, but some go as low as 7,500 while some can go much higher than 12,000. If your lease gives you an allowance of 12,000 miles and you drive less than 12,000, there is not usually a rebate of any kind, but if you drive over 12,000 miles, there is usually an overage charge, such as $0.10 to $0.25 per mile.
For instance, if you drove 13,000 miles on a 12,000 mileage lease and you had to pay $0.25 per mile over, you would pay an additional $250.
The higher the mileage allowance, the more expensive the monthly payment will be.
Taxes and Fees
Of course, there are also taxes and fees. Review the fees and see if you can negotiate any of them.
For example, if you see a doc fee, you may be able to negotiate it. There is also usually a disposition fee, which pays for cleaning if you return the car instead of buying it. This is something worth negotiating. The disposition fee is usually $300-$400.
In some states, taxes on leases are different than buying. Many states add sales tax into each payment. For example, if your monthly payment is $300 and sales tax is 5%, you would pay approximately $15 each month.
However, there are states that require you to pay sales tax upfront, similar to buying.
For example, people in New York, Texas, Ohio, Minnesota, Illinois, and Georgia who lease a car are required to pay sales tax on the sum of all lease payments upfront when signing the lease. It’s not spread out across the monthly payments during the lease term.
Here is a good guide to walk you through an actual lease.
Now that you know the leasing jargon, let’s look at a rule of thumb to determine if you are getting a good deal on a lease. Although rules of thumb aren’t great, and I’d recommend using a lease calculator, it’s a quick, back-of-the-envelope way to double-check.
One Percent Rule of Thumb – Are You Getting a Good Deal?
One way to quickly see if you are getting a good deal is to use the one percent rule of thumb.
This rule of thumb says that if you can get the monthly payment (excluding sales tax) to 1% of MSRP, you have a great deal.
For example, if the MSRP of the car you want is $30,000 and you can get a lease payment for under $300 with no money down, it’s likely a great deal.
This rule fits best for 36-month leases in the 10,000 – 12,000 mileage allowance.
Please keep in mind that this is very general. Whether you can get below 1% of MSRP is going to depend on the type of car, credit score, economy, location, etc.
You could still find a car that leases for 1.3% of the MSRP, and that could still be a good deal.
Example of Leasing a Car – Doing the Math
Let’s look at an example of a lease deal and compare it to buying next.
Maria decides she wants a 2022 Subaru Forester, but she isn’t sure whether to lease or buy.
She researches the dealerships in her area and discovers she can get a 36-month lease on a 2022 Subaru Forester for $255 a month with $2,515 due at lease signing, and no security deposit.
Digging into the details, she determines the following:
- MSRP: $26,750
- Net Cap cost: $24,125 (incl. $595 acq. fee)
- Total Monthly Payments: $9,180
- Lease end purchase option: $18,333
- Mileage allowance: 10,000 miles a year
- $0.15 cents per mile over 10,000
- Disposition fee: $300
- Other details: net cap cost and monthly payment excludes tax, license, title, registration, retailer fees, options, insurance, and the like.
The money factor isn’t included in the advertised information. She also doesn’t have the total sum of all lease charges. She could call the dealership and get this information, but she decides to do her own calculations first.
She was able to back into the money factor using a Leasehackr calculator. She determined the money factor was around 0.00213, which is equivalent to an APR of 5.11%. You can see the calculation here. Remember, you multiple the money factor by 2,400 to get the APR.
This means the total monthly rent charge is about $91 a month. Over the course of the 36-month lease, that is about $3,276 in rent charges.
Since the $2,515 is due at signing, she should add that back into the monthly payment to get the actual cost.
She divides $2,515 by 36 to get $69.86. This is the hidden cost of the lease deal, which she can add to the advertised monthly payment.
The $255 plus $69.86 brings the total monthly payment to $324.86. She isn’t actually paying this amount, but because she is paying $2,515 upfront, this should be factored into the total monthly cost over the life of the lease.
Using the 1% rule, this deal is 1.21% of MSRP ($324.86 / $26,750). It’s over 1%, but that doesn’t mean it’s necessarily a bad deal, particularly with the global chip shortage leading to a shortage of cars.
Please keep in mind that Maria won’t actually be paying the $255 a month advertised price because it excludes taxes and other fees.
Once she factors in taxes of about 5.5%, her monthly payment will be around $269.
If you include the monthly payment, disposition fee, money due at signing, and taxes, the total effective monthly payment is about $368 – a far cry from the $255 a month advertised.
This is where leases get complicated. The advertised rate often excludes key variables and is muddled by the amount due at signing.
The monthly payment can look very low if you put enough down at signing.
At the end of the lease, Maria can give the car back and lease or buy another car. Or, she can buy the Subaru she has been driving for $18,333. Recently, with the pandemic and a shortage of cars, many people can buy out their lease and sell the car for more.
For example, Maria might be able to buy the Subaru for $18,333 and turn around and sell it for $22,000, netting herself $3,667. This is rare in normal times, but it was happening in 2021 and 2022.
Finally, Maria wants to calculate the total cost of leasing. Since Maria knows her effective monthly payment is about $368, the total cost of the lease was about $13,248 over 36 months.
Now, she can compare it to buying.
Example of Buying a Car – Comparing the Math to Leasing a Car
Maria discovers she can buy a 2022 Subaru Forester with a 1.9% APR from the dealer.
She is not required to put any money down. She also is going to buy the same car for $26,750 to match the lease MSRP.
If she takes a 36-month loan, the monthly payment will be about $765 – much higher than the $368 effectively monthly payment; however, at the end of the 36 months, she will own the car outright. She can then continue driving it without any payments. She could take a longer loan term if she wanted, but she opts for the 36-month loan term.
The total cost of the loan would is about $27,541.
It’s more expensive over those three years, but let’s project out further.
If Maria can lease the same car for the same costs again (assume for simplicity), she will have another $13,248 in costs over the next three years. This brings the lease cost to $26,496 over 6 six years – about in line with the total cost of buying the car ($27,541).
The major difference will be that Maria could still keep driving past year six if she bought the car, and she wouldn’t have a monthly payment. This could go on for the next three-year lease cycle or longer.
If she did that and assuming Maria leased again for another $13,248 over three years, Maria will have spent $39,744 over nine years versus $27,541 buying the car.
This is important to keep in mind because many buy vs. lease calculators on the internet just look at the cost over the lease term. They often don’t consider the time period after the lease, where buyers may not have a loan and people leasing continue to have a payment.
People who lease cars often:
- Want a new car every few years
- Want the latest technology and safety
- Don’t want to deal with repairs
- Want simplicity
Buying a car every few years isn’t usually going to make financial sense when you could lease instead. However, for people who keep their cars for longer, you can see how buying starts to make more sense.
A lease is nice because, with a 36-month term, you are usually covered if major repairs are needed. It’s usually simpler. You pay your monthly payment, tires, fuel, insurance, and that is it.
When you buy, you may have to take on more maintenance and repairs.
So, is it better for Maria to buy or lease?
It depends on her lifestyle and how long she wants to keep the car. If she wants simplicity and a new car every few years, leasing is probably better.
If she plans to keep her car longer and doesn’t mind not having the most up-to-date features, buying is likely better.
Advantages of Leasing a Car
In general, below are the advantages of leasing.
- Higher tax deduction for business owners (usually)
- Often, a lease payment is more deductible than buying a vehicle for people who are self-employed
- Lower monthly payments (usually)
- Can get a nicer car than you may be able to afford if buying
- Latest technology and safety with a new car
- Minimal costs (usually in warranty period)
- No hassle of selling (unless you want to buy the car and then sell it)
- Less money needed upfront usually
- If the car appreciates, you can buy it and sell it to another person for more
- You only pay sales tax on the payment – not on the full value of the car
Disadvantages of Leasing a Car
In general, below are the disadvantages of leasing a car.
- Mileage allowance tough to estimate
- If you don’t use the full miles, you paid more than necessary (lower residual value)
- Expensive to buy miles if you go over
- Possible excess wear and tear charges
- Hard to get out of without fees and penalties.
- If your circumstances change (have kids, need to move, longer commute, etc.), a lease is less flexible
- Payments go on for forever
- You never have a paid off car
- Usually costs more than buying over longer periods of time
- Have to deal with leasing again and listening to a sales pitch every few years
- May need GAP insurance
- If the vehicle is stolen or totaled in accident, you still need to pay the balance of the lease, and regular auto insurance may not cover it.
Summary – Final Thoughts
Deciding whether to buy or lease a car can be a tough decision.
Some people love buying while others love leasing. Both can be good options depending on how you use your vehicle and what kind of lifestyle you want.
With a lease, you can usually get a much nicer car than you could afford if you were buying. Plus, you will likely face less money in repairs because most lease terms are not longer than the warranty on the car.
As with anything financial, run the numbers carefully. Pay attention to the fine print. What is advertised in a lease is often not what you will actually pay when all is said and done.
Buying usually makes more sense for people who are willing to hold onto their vehicles longer. At the end of a loan, they have equity in their car, whereas with a lease, you only have equity if you can buy it and sell it at the end of the loan term for more. This usually doesn’t happen.
Although the financial aspects are important, don’t forget to consider the lifestyle aspects.
Some people lease because it’s simpler.
You don’t always have to pick the option that makes the most financial sense.
Good luck in deciding whether to buy or lease your next car