Should you buy or lease a car? If you have to ask, you should probably buy.
Leasing can make sense in some circumstances for some people, but for most, actually owning the car is a better financial decision.
My car buying experience
I bought a car last summer. I opted for a 3-year-old, pre-owned vehicle that cost less than $40,000. I already knew because of the price point that I had no interest in leasing, but I deliberated quite a bit between buying it outright or financing. I ultimately chose a blended approach, making a large down-payment and then financing the rest. I automated the process to have my car paid off in full within two years (hello, 2020!). At any point, if I want to eliminate my car loan entirely, it’s only a bank transfer away. However, I’ve always been more of a “money in the bank” person and I like income generated in the stock market more than I like to have a debt balance of zero.
I personally planned to keep my car for 3 years, then trade up, but I may get the itch earlier. In any case, I made a personal deal with myself that I’m not allowed to get a new one until this one is completely paid off.
I realize the above may be atypical for the hardcore personal finance community, which varies in opinion but typically errs on the side of extreme frugality. Most financial gurus would say never pay more than $5,000 for a car and buy it outright in cash. If you want that advice, you can go read those blogs. Personally, I make money so I can spend it, and next time I’m getting a Tesla.
How much should you spend on a vehicle?
Ideally, you want your total transportation costs to be less than 15% of your net income. This means your car payment, as well as insurance, gas, maintenance, tires, parking fees, and so on. For example, if your net pay is $3,000 per month, then your total spending on transportation should be no more than $450 per month. If you spend $150 on gas and $75 on insurance, then you cannot have a car payment greater than about $200. This leaves you an additional $25/mo for incidentals or to tuck away in a car emergency fund.
RELATED POST: The Importance of a Car Emergency Fund
Because vehicles have so many additional costs, it’s really important to think of the entire cost. It’s easy to be swayed by ultra-low monthly payments of a lease or a 7-year car loan, but generally, vehicles are simply a black hole into which money disappears forever and you need to see them that way.
Whether you choose to lease or finance a car, one of the determining factors for the amount you qualify for is your credit score. You can get your free credit score and free credit report from Borrowell here.
What does it mean to lease a car?
Leasing a car is more or less a form of renting. You pay a monthly fee to drive the vehicle for a fixed term, usually two to three years, then you turn it in for a new one. Because you’re only renting, not only, you’re not responsible for maintaining the vehicle. However, it also comes with restrictions, like how many miles you can put on it each year or over the lifetime of the lease. If you go over the mileage restrictions or cause any additional damage to the car beyond normal wear and tear, you will have to pay for it at the end of the lease.
Some leases actually allow you to buy out your vehicle at the end of the lease. However, this is usually at a higher cost than if you had simply financed the car from the beginning.
When you think about leasing a vehicle, you should imagine it as the car dealership unloading the costs of depreciation of a vehicle onto you. That’s essentially what your monthly lease payment is going for. At the end of the lease, the dealership retains the car and can resell it at its residual value (possibly to you!), but they didn’t lose any money because you paid them for every month that the car decreased in value.
The people who tend to gravitate towards leasing a vehicle do so for the lower monthly payment, to drive a higher-end vehicle, or so they can claim it as a business expense.
What does it mean to finance a car?
Financing a car means to buy it with a loan. You often put down a downpayment and then amortize the remainder of the cost plus sales tax and dealership fees over the lifetime of the loan. At the end of the loan term, you own the car outright. However, you’re also responsible for all the maintenance and repairs.
Financing a car is often a better financial option for most people who need a vehicle, so long as they actually eventually pay the loan off. But you have to actually pay the car off. If you simply take out a car loan, and then upgrade your car in 3 years and roll the balance you owe into a new loan, all you really have is a very expensive lease.
RELATED POST: How to Pay Off a 7-Year Car Loan in Less Than 4 Years
The people that tend to gravitate towards financing a vehicle want to eventually own their car and have no car payment, or are shopping for a more affordable vehicle where owning makes more sense than leasing. One of the main benefits of financing a car instead of leasing it, is that after interest and depreciation, the money you put towards your loan payments does eventually become equity in the vehicle.
Cars are not great financial assets, but they’re not negligible ones either. Having monetary value in your car counts on your net worth balance sheet. It gives you more options than not having it, and when it comes to personal finance, options matter a lot. You can always sell the car to pay off the loan. If you have enough equity, selling your car might even pay off the loan in full and still give you some extra cash on hand.
Pros and cons of leasing vs. financing a car
When it comes to comparing loans and leases, make sure you look at all aspects of vehicle costs, not just the monthly payment. Here is a brief comparison of the pros and cons of leasing or financing a car:
Pros of leasing
- No down payment required
- Lower monthly car payment
- You get to drive a new vehicle every few years
- A good option if the car belongs to a business
Cons of leasing
- There are mileage restrictions and additional charges for going over
- Leased vehicles typically have higher car insurance premiums
- There is a balloon payment at the end of the lease if you want to buy out the car
- You always have a car payment since you never actually own the vehicle
- You must return the car in showroom condition, minus general wear and tear. There is a financial penalty for additional wear and tear
- There are often expensive termination fees if you want to get out of your lease early
Pros of buying
- The equity in the car is a financial asset
- You can drive the car until it is paid off, so you will eventually have no car payment
- Lower car insurance premiums
- No mileage restrictions
Cons of financing a car
- Down payment typically required
- Higher monthly payment
- Many people are typically “underwater” on their car loan for the first few years they own their car, meaning they owe more on the debt than the vehicle is worth
- You are responsible for all maintenance
As you can see, the above is quite the list! Go through each item carefully with the actual numbers so you can see a true comparison before you make your decision.
When does leasing make sense?
Leasing can make sense for luxury vehicles, which typically have rapid depreciation and exceptionally high ownership costs.
As a general rule of thumb, it’s better to own a vehicle that costs less than $60,000 and lease a vehicle that costs more than $60,000.
It almost never makes sense to lease cheap vehicles, because the lease payment is not that much lower than a loan payment, but you wind up with nothing in the end. Instead, you should find a way to afford the vehicle by either saving a larger downpayment or adjusting your budget to accommodate the monthly payments.
On the other hand, leasing expensive vehicles makes more sense because the depreciation is so substantial and repairs and maintenance are expensive, owning them is too big of a financial hit. You’re better off letting the dealership carry the repair bill instead of you! Additionally, if you’re even shopping for $60,000+ cars in the first place, chances are you have both a high income and really like new cars. These are both things that a lease serves better than a loan, in which case I say go for it.
Should you lease or finance a car?
Well, the decision is up to you. As mentioned above, I don’t think leasing a car that costs less than $60,000 makes good financial sense, but you might have circumstances that justify it. I would, however, caution you from choosing leasing simply for the lower monthly payment. At the very least, a car loan does eventually let you build equity in your vehicle. If you face the worst, like job loss, you can always sell your car to eliminate your car payment. You cannot so easily get out of a lease without financial consequences.