Ah, one of your first big financial decisions. Now that you’re finally making some money, it’s time to start thinking about the upgrade to a grownup car. Time to start weighing your options.
Finding a car you like is the easy part. A few minutes (or hours) on the internet is all it really takes to find the model you’re looking for. Next, you can head over to a dealership and start looking at some of the cars in the parking lot to see it in person.
The salesperson sees you looking and offers to let you take it for a test drive. You eagerly say yes, drive it around the block a few times and fall in love with it. Excitement has taken over, so when the salesperson asks what you think, you immediately say “I’ll take it!”
Back at the dealership, you sit down with the salesperson and start signing paperwork. After a few pages, you realize you have no idea how you’re going to pay for it. Not because you don’t have the money, but because there are multiple different options and plans that you don’t know anything about.
Relax. It’s not as hard as it sounds. However, it is important, so let’s take a look at what one option, leasing, could mean for you.
HOW DOES A LEASE WORK?
You might have heard that leasing is basically like renting a car. In some ways this is true, but in others it is very different.
A lease is a relatively long term contract, during which the lessee (you) makes regular payments to the lessor (a dealership or leasing company). This time frame is one major difference between renting and leasing. Another difference is that it is quite common to have the option to purchase the vehicle at the end of the lease, while you often do not have that ability for a rental. A third major difference is that insurance on a rental is optional, while leased vehicles require comprehensive coverage for nearly everything.
These differences probably aren’t all that important to your financing dilemma, but I thought it might be beneficial to clear that up.
First and foremost, you need to understand that leasing, like renting, does not give you ownership of the vehicle. You will be driving the lessor’s vehicle unless you take them up on an offer to purchase it. Until then, your money will be going to the vehicle’s owner.
A lease generally will require you to make monthly payments. These payments are primarily made up of depreciation and the lease’s money factor. We should look into what those mean.
As we all know, a car’s value decreases over time. This decrease in value is referred to as “depreciation.” Since it’s stupid for a business to willingly lose money on your leased car, they’re going to pass this expense on to you. Depreciation will become part of your monthly lease payments.
Basically, the vehicle’s owner will take the difference between the current purchase value and the value they expect the car to be at the end of the lease (called the residual value), and will spread the difference over the term of your lease, generously passing on these costs to you.
For example, say you have a 3 year lease and the owner expects the car to depreciate from $25,000 to $15,000 by the end of the term. If you divide that $10,000 difference by 36 months, you can see that the depreciation alone will cost you about $277 per month. (Can you choose how long you lease or is that their call or how do you get out of a lease)
That’s a decent chunk of cash.
The second major component of your monthly payments is called the money factor. Unfortunately this is a bit more confusing and likely leads many people into a poor decision. You will often need to ask the owner for this number because it typically is not included in the lease contract.
Essentially, the money factor is sort of like interest on a loan. It’s used to find how much you’re going to pay the vehicle’s owner in exchange for using the vehicle. The confusing part is that a money factor is an extremely small number, like 0.00125, and this number by itself means nothing. To find how much this will actually cost you, you need to multiply the money factor by 2,400.
Random, I know.
As an example, let’s use that 0.00125, which is a pretty realistic rate. If we multiply that by 2,400, that means we get a 3% annual percentage rate (APR). This APR will help us find how much we will be paying the owner to let us drive their car.
If we go back to our earlier example with the $25,000 car, we can find our monthly payment by multiplying the value (of the new car in the beginning) by our APR and then dividing it by 12. So, $25,000 multiplied by 0.03 (3% APR) and then divided by 12 months leaves us with $62.50 per month.
Your grand total for the monthly payment is around $340 each month ($277 + $62.50).
If you’d like to calculate the monthly costs for other vehicles, check out Edmund’s CALCULATOR!
This number assumes that you had no down payment for the car and no other additional monthly fees. Most leasing companies will require a small(ish) down payment, along with various other fees associated with starting the lease. You will also be required to pay for better insurance than you would on a vehicle you own. It’s pretty safe to assume that you’re going to be spending $1,000+ before your car even spends one night at your house.
Another potentially major fee is the mileage fee. Many contracts will specify how many miles you can drive the car each year. Pretty average amounts fall between 12,000 and 15,000. If you go over your allowed amount, you will have to pay somewhere around 10 to 15 cents PER MILE that you exceeded it. Just something else to be aware of.
At the end of your lease term you may also be required to pay for any damage to the vehicle along with several other fees. All of the fees and payments can really add up over the course of the lease, so make sure that you keep track of these expenses and understand what you’re getting into.
Geez, whenever I explain activities related to spending money, I always feel like I’m painting them in a negative light. It isn’t (always) my intention, I swear.
SO… WHY WOULD ANYONE CHOOSE TO LEASE A CAR?
I’m not going to claim to know everything about leasing, so don’t take these lists as comprehensive and complete. There will be other pros and other cons. I’m sure of it. If this list doesn’t satisfy your appetite for knowledge, do a bit more research and see what others have to say.
Alright, let’s break this down to two simple lists: pros vs. cons.
- Low, or no, down payments
- You can drive a new vehicle for less money than buying
- At the end of the lease, you don’t have to worry about selling the car
- Repair costs will be very low because the car is new (and hopefully under warranty!)
- Every time your lease ends, you can simply lease a brand new car and continue the cycle
- You build no equity in the car, meaning you have zero ownership
- Extensive fees associated with various aspects of the vehicle
- Potentially higher insurance costs
- There are high termination fees if you end the lease early
- You can’t do any permanent customizations to the vehicle
In the end, it is important to weigh the costs and benefits and decide what works best for your circumstances. While this article touches on many points that you may not have known, there is still a good amount of information out there that you may find useful.
Do your research. Figure out if you’re okay with having a monthly payment and how much you can actually afford. Find your car, ask questions and become as informed as you can.
If you decide that a new car every couple years is right for you, I hope you enjoy that new car smell.
Do you or anyone you know lease a vehicle? Why did you/they choose it over buying? Leave a comment below and share the wisdom!