A friend is thinking about dumping her old rust bucket and getting a new set of wheels. Her current car is the first one she ever bought and she found it for cheap on Craigslist. The car has done her well over the last couple of years but she’s moved up in the corporate world and is ready to buy a new car.
One of the first questions she asked me was, “Why shouldn’t I just lease instead of buy?”
Leasing does have its advantages:
- Get a brand new vehicle every 2-3 years
- Always have your vehicle covered by an extensive warranty
- Lower down payment
- Generally lower monthly payments
- You never have to deal with the hassle of trying to sell your car
But, unfortunately, leasing has one major disadvantage: guessing the residual value of the car (or the depreciated value of the car after the lease ends) is really hard to do. The residual value is what you have to pay, at the end of the lease, to purchase the vehicle. The problem many customers have with negotiating residuals in their contract is that the customer isn’t aware of the rate of depreciation for that particular vehicle. Makes and models depreciate at different schedules and forecasting the rate of depreciation is difficult.
As an example of a poorly negotiated residual value, let’s say you’ve negotiated that your residual on a lease is $12,000. This means that after the lease is up in three years if you want to buy the car you need to pay $12,000. But what if three years down the line, that the car is worth only $9,000?
That residual value is more than the car is worth and you cannot re-negotiate the residual value after you sign the contract. This puts the customer is in a difficult situation because the calculus needed to decide whether or not to purchase the car after lease becomes even more complicated.
Leasing can have some other costly disadvantages if you’re not careful:
- Not watching the odometer: Leases have very strict mileage restrictions that, when you surpass them, get very expensive very quickly.
- A total loss is often considered early termination: If you’re involved in an accident and the car is a total loss, your insurance company will pay for the loss of the car but you’ll likely be stuck with some heavy early termination fees.
- You have to return the car in good shape: You and you’re leasing company probably have a very different idea of what a 2-3 year old car that is in good shape looks like. Expect to get every small ding and scratch repaired before you turn in your vehicle or be prepared for some heavy fees.
- Bank or acquisition fee: After you negotiate the lease terms, you can expect the salesman to drop an approximately $500 bank or acquisition fee on you.
- Increased insurance costs: Leasing companies often require drivers to have more insurance coverage than the state mandates. So expect your premiums to go up slightly.
- Leasing is financially complicated: Do you know what Cap Cost is? How about Residual Value or Money Factor? The information disparity that exists between the average person and a salesman means that you probably won’t the value for your business that you deserve.
Buying a car, instead of leasing it, has essentially the opposite benefits and disadvantages. When you purchase a vehicle you are essentially buying an asset (albeit a depreciating one) that you increasingly own as you make your monthly payments. When you pay off your loan you not only get to use your car without additional payments, but you re-enter the car market you can sell your vehicle to capture the car’s “unused value.” And, of course, you don’t necessarily have to spend as much time worrying if you were able to forecast the car’s residual value when you purchase it.
Financially, leasing doesn’t make sense for most people. If you are debating whether to buy or to lease, you should really err on the side of buying unless there is a specific reason for you to lease.
For some small business proprietors, lease payments may be tax deductable as a business expense (check with your accountant). Others who don’t own their business but use their vehicle for business purposes, such as realtors, may also be able to deduct their lease payments as a business expense (again, check with your accountant). If you are able to deduct your lease payments that would may be a compelling reason to lease a vehicle rather than buy one.
