Should You Lease a New Car?
It seems like every weekend I hear about another friend leasing a new car. So I thought it'd be good to figure out if this is the deal of the century or the deceit of the century. Should you lease a new car?
What is a Lease?
We'll start by defining a lease. A lease is a lending method that allows a consumer to obtain a new car while only paying a portion of the car's cost.
You should immediately be suspicious here. Something has to be up because when you see a financial lending tool the lender will always be on the positive expected value side of the transaction. In other words the lender is on the side of the transaction to come out on top. And in turn the leasee is on the negative expected value side of the transaction.
Think of the concept of leasing a new car as similar to renting a new car – the bank owns the car and you pay them a monthly rate to use it. The most common timeline for new car leases is about 3 years. So let's use that. And lease owners often believe their lease is well worth it because the new car is much more reliable and comes with a 3 year warranty to cover any mechanic costs.
Not bad, I initially think. But let's keep digging.
Let's bring in the real life situation. The last friend I met had just leased a cute turquoise 2016 Prius.
Here's how the purchase went down. The bank pays $25,000 to the car dealership, and my friend signed a contract with the bank to lease the bank's car for 3 years. In the contract she agreed to two things:
A. To pay for the car's depreciation over those 3 years.
B. To pay a money factor (think interest on a loan) to compensate the bank for letting you use their car.
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Car Depreciation Payment
Now here's where things start to fall apart on the beautiful new lease.
The depreciation of a new car's value is the gnarliest, most guaranteed depreciation in the land of ownership. Think flameblower spewing hundreds of dollars (your freedom) straight into the abyss.
A new car depreciates (loses its value) by 10% the minute you drive it off the lot, by 25% one year later and by 50% just three years in! So in this lease contract, my friend is agreeing to A. Pay for the 50% depreciation of the new car during the 3 year term. But wait, there's more.
The kicker here is that while they pay that depreciation they are never granted any equity in the car from their payments. In other words their money goes straight to the bank. Think rent payments. They never actually buy the car or any portion of it. The bank owns 100% of the equity or value of the car.
The other part of the lease my friend is agreeing to is to B. Pay a money factor on the agreed lease amount.
A money factor is very similar to the interest payment paid on top of a loan's principle. They give you $10,000. You pay $11,000 back. The money factor is the $1,000 above the loaned money that comes from your pocket.
You would be rational to think that in the $10,000 example above the money factor would be 10%. And you'd also be rational to think that the leaser would have to show you the money factor in the lease contract. But neither are true.
Here's how the money factor works. The leaser is not required by law to show your money factor in the lease agreement. To find it you have to ask your leaser for it. Once you have the money factor you times it by 2,400 and that gives you the interest rate or APR on the lease.
To summarize, a money factor is a term financial institutions created to confuse leasees into thinking they are getting a good deal. Don't let them take advantage of you!
At the signing of the lease I would expect that my friend went through a few fees such as title fees, acquisition fees, security deposits, and others. Then to drive the car she had to pay registration and begin paying insurance on the new car.
And it's not unlikely she'll be hit with a number of fees at the end of her lease. If she decides to buy the car she'll likely have to pay a purchase option fee. Or if she decides to return the car to the bank she'll have to pay a disposition fee. There's also mileage fees if she goes over the mileage amount in the agreement as well as wear and tear fees. And I'm sure the leasers are real lenient on those. ;)
Total Cost of My Friend's New Car Lease
With the specifications and calculations below my friend's new car lease looked something like this:
Lease length: 3 year/36 month
New car cost: $25,000
Depreciation fee: $12,500 (or 50% of car's initial value)
Money factor: .004 (or .004 x 2400=10%)
Beginning and end lease fees: $2,500
Vehicle registration & Tax: $2,500 (quote from ca.dmv.gov)
Insurance: $2,000/yr (quote from Geico)
Miles to the gallon: 50
Annual Mileage: 15,000
Mechanic costs: $0 (covered by warranty!)
Monthly lease payment: $500/mo = $350 + $150 = ($25,000 - $12,500)/36 + ($25,000+12,500) x .004
Monthly car insurance: $165/mo
Total Cost of My Friend's 3 Year Car Lease: $31,500
That's $31,500 with $0 in equity on the car itself, so nothing left to re-sale.
How to Buy a Used Car without a Lease
Now that we have the numbers on the leased car let's talk about buying a used car without a lease. We'll use the same numbers as above wherever possible.
Choosing the Right Car
As for picking the car, we head over to Mr. Money Mustache's article titled, The Top 10 Cars for Smart People. These are the cars that will last well well above 150,000 miles with minimal mechanical needs and have great gas mileage with tons of space.
After looking at that list we choose to purchase a 2010 Honda Fit. We estimate that we'll use it for 3 years and drive 15,000 miles each year on it, so even with a huge safety margin of 100,000 max miles, we decide to get a Fit with 55,000 miles or less.
After a Kelly Blue Book search we find that a 2010 Honda Fit with these specs should cost $8,600. On we go with the search!
Next you read another legendary article from Mr. Money Mustache that shows you the best way to purchase the car. Then you take 10 minutes and get the internet to email you any new Craigslist post that meets the Honda Fit your looking for.
A week or two in you see a great deal with a well photographed car, on-point description and all mechanical records for $8,600. You meet the owner, test drive the car and take it to a friend/co-worker approved mechanic to have it checked out. It passes and you get it! Wahoo!
Used Car Depreciation
Being that our Honda Fit is 6 years old it has already lost a whopping 65% of it's initial value. That's great because that's the past owner's loss. Over the next 3, even 10 years, the depreciation will be much, much less. Think maybe $800/yr.
Getting a solid used car after it lost 65% of its value during those first 5 years is so powerful. It gives you the ability to put massive amounts more of your money into things you love instead of your car.
This is the part leasees often use to make themselves feel they are making the better decision. But if you do your due diligence to make sure you get a reliable car (think Toyota or Honda) and ALWAYS have it checked by a recommended mechanic before purchasing, you are setting yourself up to have minimal mechanical issues.
But let's just say we hit a couple flubs along our 3 year path. Let's say you had to spend $2,500 over the 3 years on the Honda Fit's mechanical issues.
Selling Your Car
Continuing the story 3 years down the road we find it is time to move on from the Fit. At this point you have 100% of the car's equity. So you get to sell the car and keep 100% of the sale price.
Total Cost of Buying a Used Car
So all in all here's how we did after purchasing the used car:
Ownership time frame: 3 years
Car cost: $8,600
Vehicle Registration: $900 (quote from ca.dmv.gov)
Equity depreciation: $2,400
Insurance: $600/yr (quote from Geico)
Miles to the gallon: 40
Annual Mileage: 15,000
Mechanic costs: $2,500
Sale Price: $6,200
Total Cost of 3 Years of Car Ownership: $13,500
Should You Lease a New Car?
Leasing the new car cost my friend $31,500. While buying the used car costs $13,500. The used car put us $18,000 ahead in just 3 years. That is some real meaningful cash.
That's $6,000 every year. Put that $6,000 in an index fund and let those dollars work with their 7% long term growth for 30 years and you will end up with $650,000! And we are just talking from a freaking car purchase!
Think about the people that continue down the 3 year on-going lease path. In just 10 years they've lost $60,000 to a bank so that they can sit in a more shiny car for 3 years (or $100,000 if contributed to an index fund).
The only time it would make sense to lease the new car is if the Honda Fit had $18,000 in mechanic fees in 3 years. And the likelihood of that happening is small.
So Why Do People Lease New Cars?
It's obvious now that the benefits of leasing a new car has no relation to stashing money to give you more freedom to do the things you love. So why would someone lease a new car?
These are some of the common reasons leasees may tell you they lease new cars:
1. There's a lower cost up front.
2. You get to drive a better car for less money.
3. You will totally save money on maintenance costs.
4. You can build your credit with the payments.
All of those statements are true. But each statement is missing the bigger picture.
1. There's a lower cost up front, but in just the 3 year term the cost is much, much higher.
2. Would you rather drive a better car for less money or have $650,000 in your bank account in 30 years to do more of what you love? You pick.
3. Maintenance costs may be less expensive, but that's only on a line item basis. It's like saying, "The cups at this wedding venue are cheaper, so let's pick this wedding venue." You got to bring the comparison out to the full picture.
4. You do not need a car lease to build your credit. You can build your credit in hundreds of better ways. Like using a credit card for all your regular spending and paying it off on time. Or using a credit card to purchase a used car and paying that off on time.
With all those seemingly rational reasons proven irrational, then why?
A person leases a car because 1) They incorrectly believe that the lower upfront cost saves them money or 2) That sitting in a new car somehow accomplishes the American Dream or 3) They understand the math and don't mind the losing the extra $18,000 every 3 years.
If it's number 3, then I am all for it. Truly! If you value sitting in a shiny car that much after recognizing its cost then you are following what you love. And I am for that. But I'd bet that way more often than not people lease under misconception number 1 and 2.
So What Will You Do?
Way more often then not you'll find a pretty damn similar situation to the one I laid out above. So buy a used car. But even more so I recommend just running the numbers no matter what. Either way you'll have more information to help you make the best decision for your life. And that's all I could hope this article does.
If you're interested here's how I purchased my last car for $900 (and the mistakes I made before that!).
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