While my wife has been in her medical residency, we’ve delayed making some larger purchases knowing after she finishes this time next year, our financial picture will change.
Some of the major items of note for us will be the beginning of repaying her student loans from medical school, making a move into a bigger place suited for starting a family, continuing to set aside money in our employer-sponsored (401(k)) and individual retirement accounts (IRAs), and replacing her aging Honda C-RV, among others. Meanwhile, my 2010 Toyota Camry will have to make it at least another few years.
She will have driven her vehicle for almost a decade by the time she finishes her residency and will be in need of a new one in the near future. Balancing all of these competing financial demands will be a challenge and require careful financial planning and prioritization.
In looking at how to finance this new vehicle alongside our other pressing needs, I’ve taken the opportunity to research the pros and cons of purchasing vs. leasing a vehicle. Please read more below to see which option is right for you.
In Search of a New Vehicle
As you read above, we will shortly be in need of a new vehicle. Perhaps your vehicle, too, is nearing its expiration date and you’re in need of a new one? Or possibly you’ve had a life event that requires a different size vehicle? Or maybe you’re just ready for a change?
Whatever the reason, you’re probably looking into your options, and sizing up both your needs and how much vehicle your budget can afford.
After shopping around, you’ve found the one you like. The next step is figuring out how to pay for it. You will be happy to know that you’ve got two main options to make it happen: buying and leasing. Both present benefits and drawbacks, depending on your desired outcome.
As interest rates hit all-time lows in the past decade, many people have found leasing options attractive. Traditionally, luxury vehicles made up the majority of leases but recently, more affordable vehicles have entered the lease market.
In total, around 30% of new vehicles have been leased. Because leasing has grown in popularity in this low interest rate environment and is the less familiar option, it’s important to understand how a lease works.
How does a Lease Work?
As opposed to purchasing a vehicle, where the buyer is responsible for the entire purchase price by paying with cash up-front or financing with a loan, lessees (people who lease the vehicle) only pay for the difference in price negotiated with the lessor (vehicle owner leasing to lessee) and the vehicle’s expected value at the end of the lease term.
This difference is referred to as the “residual value”. In other words, the lessee does not pay for the entire price of the vehicle over the lease term, but only for the depreciation (or loss of vehicle value) incurred during the lease term.
At the end of the term, if the lessee has followed all of the lease rules and owes nothing more to the lessor, the agreement has been completed and the parties go their separate ways.
Pros and Cons of Buying vs. Leasing a New Vehicle
Now that we have an idea of how leasing works, let’s examine the pros and cons of buying a vehicle compared to leasing one by looking at the table below.
*taxes vary by municipality, city, or state and may not be required
What is Gap Insurance?
Something to note is the gap insurance mentioned in the chart above. This is insurance which covers the lessee against any unexpected “gap” between what a vehicle is worth and what you owe on the lease agreement at the time of return or accident.
Your vehicle insurance will likely cover most of the depreciated market value at the time of an accident. However, in most cases, because lease payments are lower than monthly auto loan payments (see below) and vehicles tend to realize the most depreciation early in their lives, the market value of the leased vehicle will be much lower than what is owed by the lessee on the lease agreement.
Despite your vehicle insurance covering most of the depreciated market value, there may still be a “gap” which isn’t covered and will require a separate insurance policy. This is especially true at the beginning of a lease because, as I said before, depreciation of new vehicles happens the quickest at the beginning of a vehicle’s life.
For example, to calculate the “gap” you wish to cover in an insurance claim is as follows:
Amount owed for lease agreement
<Payment from standard insurance policy>
Amount you still owe
Fair warning, this amount could wind up being in the thousands of dollars. Gap insurance would help to cover this difference.
This gap can present as the result of an accident, loss or upon turn-in and the value significantly differs from the agreed upon turn-in value. Some lease agreements might use the term “lease coverage” instead of “gap insurance” and already include this amount in your agreement. Be sure to check the fine print to know what coverage you have.
Buying vs. Leasing a New Vehicle
Whether you choose to buy or lease your vehicle, the real out-of-pocket cost is not the price paid to the dealer (unless you bought with cash). To compare the total costs of both scenarios, you will need to figure in financing costs and applicable fees across the life of the lease contract or auto loan.
Below, I break down the costs of two using fairly standard terms available to creditworthy borrowers.
Some of the assumptions used include using a 6-year auto loan and a 3-year lease. With loans, it should be noted that the longer you finance, the higher interest you will pay in terms of rate and cost.
Depending on your circumstance, it may make sense to seek a longer-term loan to make the monthly payments fit within your budget. Each person’s situation will vary.
Typical auto loans are 5-7 years in length (though, it’s not unheard of for loans to stretch to 8 years), but 6 has been used for this example in order to show how an average 6-year loan compares to leasing two vehicles back-to-back with successive 3-year leases. We made the following assumptions:
- Vehicle has a manufacturer’s retail suggested price (MSRP) of $25,000
- $2,000 due at lease signing
- Buyer finances the entire purchase price, including 8% sales tax, with auto loan ($25,000 * 1.08 = $27,000 financed)
†does not reflect standard maintenance costs; leased automobile could have maintenance costs covered under lease agreement, thereby making this difference bigger
It’s clear that the total amount paid after 6 years favors the lease option, however this leaves you without a vehicle. After weighing the math and various benefits and drawbacks charted above, the choice isn’t necessarily clear.
One other consideration not mentioned above is the ability to deduct depreciation against an owned vehicle if used for your business. Claiming this tax deduction requires learning how to read MACRS depreciation tables and understanding Section 1231 property but can make the purchase worthwhile.
Aside from the tax consequences, the main decision comes from what you value and what your ultimate goal is with the vehicle. If you place more importance on driving the latest and greatest because you tire of vehicles easily and don’t want to be committed to one vehicle long-term, then maybe a lease is right for you.
Or maybe you will only be in this location for a limited amount of time and don’t want to deal with the hassle of selling a vehicle you purchased when you’re done with it. However, if you’ve had your last vehicle since tape decks were part of the standard package and you intend to do the same with this one, buying is your clear choice.
Another consideration is what you could do with the extra money not spent on purchasing the vehicle. Because buying the vehicle costs more over the 6-year time frame, you face opportunity costs, or the loss of potential gain from other alternatives when one alternative is chosen, associated with the extra money paid.
Were you to invest the $99 difference per month in an asset which earns 7% interest annually, you could have an extra $8,647 on your hands after 6 years. As I’ve written before, compound interest is your friend.
Each person will value different aspects of purchasing or leasing a vehicle. If the question is finding the best possible deal on a reliable vehicle, you might consider a different option altogether.
The Smarter Way to Get a New Vehicle
If your main desire is to find the best possible deal on a dependable vehicle, you should consider buying a certified pre-owned vehicle. Using the same depreciation calculator as above, that $25,000 vehicle would be worth $14,665 after 3 years, saving you $10,335.
Imagine taking out a 4-year loan on this balance and paying the same amount as how much you would have paid on the lease ($339/mo). Doing this would give you a lower monthly payment than buying new, leave you with equity, and have a vehicle still covered by the manufacturer’s powertrain warranty throughout your ownership.
To state the obvious, following this route doesn’t give you a new vehicle, but if you planned to own the vehicle for 6 years, regardless, then you were prepared to drive a 3-6 year old vehicle. Why you would want to lease is because you prefer to drive a new vehicle every few years, not because it’s the greatest deal ever.
As for owning, assuming your choice has a dependable maintenance history, there really aren’t convincing financial reasons to buy new besides having that new vehicle feel.
Simply stated, if you’re going to hold the vehicle until it dies, you clearly don’t prioritize having the latest and greatest. If so, just buy a used vehicle using either cash or a shorter-term auto loan.
If you’re choosing not to hold on to the vehicle for at least 6 years, you’re not saving money on the monthly payment and are only left with a residual value. As stated before, taking the savings from the lease option’s monthly payment and investing it leads you to roughly the same place in terms of equity.
So I ask, if you’re planning to drive the vehicle into the ground, financially-speaking, why do anything else?
Our Choice for New Vehicle
For us, we know we’d like to own the car because we tend to hold onto our higher-ticket items for longer periods of time (hence the two vehicles nearing their tenth birthdays). Therefore, leasing isn’t an option we intend to pursue.
The next question is which vehicle my wife wants and then weighing the total expected lifetime maintenance costs. I’d prefer to keep those on-going maintenance expenses on the lower side if at all possible.
I imagine she will want to start her new job on a fresh note with a brand new vehicle and its accompanying new car smell. I, on the other hand, will likely be looking at something pre-owned when my car’s time comes due for the reasons expressed above.
About the Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey to reach a Millennial retirement and connect with and help others who share the same goal.
Some of my favorite things to discuss include investing in index funds, how to save money, travel hacking with help from the Reddit churning community, house hacking and optimizing the benefits of my condo vs. apartment living, and tax topics like the earned income tax credit, common tax deductions, tax reform in 2018, or other useful tax topics. I want this to be a journey for us all to learn how to make a lot of money and pursue the lives we want.
Please continue to watch the site for more to come and post below with your questions or comments.
I have not been compensated by any of the companies listed in this post at the time of this writing. Any recommendations made by me are my own. Should you choose to act on them, please see my the disclaimer on my About Young and the Invested page.