Should You Buy or Lease A Car?
The most common questions that I receive when clients are about to purchase their next car is “should I buy it or lease it?” The answer depends on a number of factors including how long do you typically keep cars for, how many miles do you drive each year, the amount of the down payment, maintenance considerations, or do you have any teenagers in the family that will be driving soon?
The most common questions that I receive when clients are about to purchase their next car is, “Should I buy it or lease it?” The answer depends on the following items:
How long do you typically keep cars for?
How many miles do you drive each year?
Amount of the down payment
Maintenance considerations
Do you have any teenagers in the family that will be driving soon?
When Should You Lease A Car?
Let’s start with the lease scenario. The leasing approach tends to favor individuals that keep their cars for less than 5 years and don’t drive a lot of miles each year. The duration of ownership matters because most cars are considered depreciating assets, meaning they decrease in value over time, and the lion share of depreciation on a new car typically happens within the first few years.
Example: If you buy a brand-new car for $40,000 and a year or two from now if you wanted to sell that car, you would receive less than $40,000. You may only receive $35,000 or $30,000 depending on how well the type of car you purchased holds its value which varies from car to car.
If you are the type of person that likes driving a new car every 3 years and you were to buy the car instead of lease it, you are incurring the lion share of the depreciation in value every time you buy a new car and then trade it in or sell it every few years. When you lease a car, you technically do not own it, you are borrowing it from the dealer, and you are entering a contract with the dealer that specifies how long you are allowed to borrow the car, the mileage allowance, and the buyout price at the end of the lease.
When the car lease is over, you drive the car back to the dealer, hand them the keys, and you don’t have to worry about what the trade in value will be. If you decide you want to buy the car at the end of your lease, the lease contract typically has a set purchase amount that you are allowed to buy the car from at the end of the 3-year lease term.
Mileage Matters
When you enter into a car lease, there is usually a mileage allowance listed in your contract that states the number of miles you are allowed to log on the odometer during the duration of the lease agreement. Most 3-year lease agreements provide a 10,000 to 15,000 mileage allowance each year, so your 3-year lease agreement may be limited to 30,000 miles during the duration of the lease. If you go over that mileage allowance, there are usually fairly steep mileage penalties that you have to pay at the end of the lease agreement. Typically, those milage fees can be $0.10 to $0.30 per mile.
Example: If your 3-year lease has a 30,000-mileage allowance, but you drive more miles than expected and turn in the car with 40,000 miles at the end of the 3 year period with a mileage penalty of $0.25 per mile in your lease agreement, you would owe the dealer $2,500 when you go to turn in your car.
When individuals go way over their mileage allowance, instead of just handing the dealer a big chunk of cash, and then not having a car, you may have the option to take out car loan at the end of the lease and buy the car from the dealer at the set price listed in your lease agreement.
Leasing Risks for Young Professionals
I think mileage is one of the bigger risks when leasing a car, especially for young individuals that are just entering the work force. Why? Because life and careers tend to change at a rapid pace between the ages of 20 and 40. These young professionals may be working for an employer now that allows them to work fully remote, so they put minimal mileage on their car and decide that leasing the car is the way to go. However, what happens when that individual is offered a much better job that requires them to go into an office setting and the office is 30 miles from their apartment? Now, they are going to start logging more miles on their car which could put them over the mileage allowance in the lease.
Lease: No Down Payment
The first two questions that the car salesman asks you when you enter a dealership is:
What were thinking about for a monthly payment?
How much were you planning on putting down on the car as a down payment?
If you want to buy a new car, in most cases, buying the car versus leasing the car is going to be more expensive out of the gates because remember, when you buy the car you own it and when you lease the car you don’t own it, you are just borrowing it. With a lease, since you don’t own the car, they may offer a new car with no down payment, and the payments may be lower than buying the car outright…..again…..because you don’t own it. Your monthly payments just go directly to the financing company without you ever owning anything. It’s a similar concept as renting an apartment vs buying a house.
However, if you typically trade in your cars every three years for the newer model, as long as you can stay within the mileage allowance, leasing could make sense because unlike a house that’s an appreciating asset (which means it gains value over time), a car is a depreciating asset which loses value over time. So, if you are trading in cars every three years with the benefit of realizing a loss in value every three years, it may be better to borrow the car and use your additional cash to meet other financial goals.
Maintenance Costs
When you lease a car, often times it removes the risk of incurring big costs associated with fixing the vehicle if something major goes wrong. It’s common for the lessee to be responsible for routine maintenance like oil changes, but leased cars are typically new and covered under warrantee for most major issues that could arise.
When Should You Buy A Car Instead of Leasing?
Now onto the buy section. When should you buy a car instead of lease it? The first question I always ask is how long do you drive your cars for? If someone says 5 years or more, it almost always favors buying the car instead of leasing it. While you will have a little more cost up front, because purchasing a car usually requires a downpayment, you open the opportunity to visit the land of “No Car Payments”.
For anyone that has been to the “Land of No Car Payments” it’s wonderful. If you enter into a 5-year car loan and you drive that car for 8 years, you have 3 years of no car payments. It’s like driving a car for free. With a lease you will technically always have a car payment, even if you front all the money at the beginning of the lease, because you never own the car. At the end of the 3rd year, you still have to buy it at a price that may be above what the market value of that car is at the end of the lease.
The car still depreciates in value but if you own a car for 6 years and have 120,000 miles on the car, as long as you have taken care of it over that 6 year period, you car will typically still have value, so when you go to trade it in to buy your next car, you down payment may already be covered by the trade in value.
You Drive A Lot
If you drive a lot, whether for work, pleasure, or both, it tends to favor buying a car because it’s unlikely you would be able to stay within the mileage allowance of a lease, and big mileage penalties would be waiting for you at the end of the lease agreement.
Buying A Car: Bigger Down Payment & Higher Monthly Payments
We covered this topic in the leasing section but it’s worth repeating. It can be very tempting to enter into a lease since there may be no downpayment, a low monthly lease payment, which may get you into a newer or nicer car, and all too often people underestimate how much they drive each year mileage wise. While you may work for home, how many miles do you drive taking the kids back and forth to school, practices, dinners, friends houses, family vacations, grocery store runs, meeting friends for dinner, etc. Unless you have owned cars for a number of years, and life is relatively unchanged compared to past years, it often tough to judge how many miles you will log on that car over the next 3 years outside of the life surprises like moving or changing careers.
Buying a car and not having to worry about staying within a mileage allowance takes that financial risk off the table.
Car Maintenance
When you own a car, you have the option of buying extended warranties which adds to your monthly payments on the vehicle. These become a personal preference of whether or not these extended warranties are worth the money, but if you opt not to go with robust extended warranties, you have to make sure that you have enough cash reserved in case your vehicle requires an expensive repair that’s not covered by warranty after the first number of years, that you will have the cash to pay for it. It just takes some extra planning on the part of the car owner.
Teenage Driving Soon
When I'm consulting with clients that are about to buy a new car and have children between the ages of 12 and 16, I'll sometimes ask the question, “What's the plan for when their child turns 16 and begins driving?”. Depending on the type of car they're buying, would it potentially be a long term financial planning move for the parent to buy the car, drive it for four to six years, and then when their child gets their driver’s license, they have a used car that has been paid off, taken care of, ready to go, and then the parent can go out an get a new car at the time of the hand off. It’s a plan that has worked well for several clients which favors buying the car versus leasing.
Avoid 6 to 8 Year Car Loans
We have seen a rapid rise and the number of consumers that are taking car loans with a duration of six to eight years. The conventional auto loan used to be five years, and nothing beyond that was offered, but now we see car dealerships starting the conversation at a seven-year car loan in an effort to make the monthly payments lower. However, this created a new problem called the negative equity trap. Since, again, a car is a depreciating asset, it loses value over time, and if at the time you go to trade it in the loan outstanding on the car is higher than the value of the car itself, you get stuck in what’s called a negative equity event, where the outstanding car loan is higher than the value of the car.
Auto dealers will often address this by allowing you to roll over your negative equity to your next car. Meaning if you're upside down by $3000 when you go to trade in your car and you buy the new car for $40,000, the car loan will be for $43,000. The problem is, your negative equity problem just got larger with the next car because you're already starting at a higher loan amount than what the car is worth. If you do this a few times people will sometimes reach a situation where the negative equity amount has become so large that banks will no longer allow them to roll that into the next car loan and they get stuck.
When buying a car, I often encourage individuals to avoid the temptation of the six to eight-year car loan and stick with the five year conventional auto loan to avoid these negative equity events.
What Does The Investment Advisor Do?
Sometimes my clients will ask me “Mike, what do you do?” I’m a buyer of cars mainly becuase I drive a lot miles each year and I typically keep cars for 7 to 8 years. But if I was an individual that drove under 12,000 mile each year and enjoyed trading in my cars every 3 years, then I could see how leasing would make sense. The decision to buy or lease truly depends on the travel habits, ownership duration, debt preferences, budget, and new or used car preference of each individual buyer.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
