Should I Buy or Lease a Car? – The Long-Term Solution

November 12, 2015 The Fire Guy 7 comments

If you hate reading, found this through google and just want an answer to this question: DON’T LEASE!

For everyone else:

Over the years, I’ve seen numerous blog posts and webpages asking the age old question, “Should I Buy or Lease a Car?” One thing that I haven’t seen is the long-term analysis of this question. Usually the tools focus on a singular decision, but the reality is that life is about a long-term string of choices. Below serves as a guide for a long-term scenario to this common question.

The Scenario:

In our fictional scenario, we will assume we are sitting in the magical year of 2016. We just graduated from college at 22 years old, got a spankin’ brand new job, and we need a car to make that hour long commute in. Three options are presented to us for acquiring said car. We can:

  1. Buy Car (Cash)
  2. Buy Car (Loan Financing)
  3. Lease Car

Because we are looking at the long-term implications of this decision, we will also assume that once we go down one of  the 3 yellow brick roads, we stick with the same acquisition method for the next 48 years (until we are 70 years old). Obviously, our method of obtaining a car could change over time, but in effort for a meaningful comparison, we will stick with this simple assumption. Below are some of our additional base assumptions:

  • Purchase Price of Car in 2016: $33,560 (this is average – people are cray cray…)
  • Annual Depreciation Rate: 17%
  • Inflation Rate: 2.5%
  • Interest Rate: 4.5%
  • Both Buying Methods: New Car every 7 years
  • Lease Method: New Car every 3 years

So just a couple of notes on these assumptions. I know cars don’t straight line depreciate, but this gets us down to about 57% of purchase price after 3 years. This is probably pretty realistic for most cars. You may be thinking the interest rate assumption is too high, but remember we are looking at a long-term case here. Though car loans today are lower than 4.5% for prime borrowers, they will likely increase over time (since we are in a historically low interest rate environment). I believe this assumption is actually quite conservative, as over the next 50 years I would expect this average rate to be more in the mid-to-high single digits (I don’t know why I typed this – no one knows where interest rates will be 50 years from today).

For both buying methods, we will assume that we get a new car every 7 years and also that we will take out a 6 year loan on the car for the financing method (DAYUM – that’s a long time). Not unrealistic, since amazingly the average car loan is up to a whooping 67 months. Crazy. At the end of the 7 years, we will also assume we use all the proceeds from the sale of our current vehicle towards the purchase of our next vehicle.

On the leasing side, it was interesting to research all the pieces of the math puzzle that make up a lease. If you’re not familiar with a car lease, here is usually how it works:

You make a down payment on the car (usually 10% of purchase price). The remaining value is something called the capitalized cost. At the end of the lease (3 years in this case) you have an assumed residual value based on depreciation rates (remember this is 17% annual depr. rate).  The other important piece of information in this calculation is this weird term called “the money factor”. It sounds like a fun game show, but later you’ll see how this kills you slowly over time and is not a fun game show.

Money Factor = Interest Rate / 2400      or in our case      4.5/2400 = .001875

So with this information we can now see our total cash outflows on each 3 year car lease:

  1. 10% down payment of car price
  2. Monthly Depreciation Cost (we are paying for the depreciation that is used up in our 3 year lease)
  3. Monthly Interest Cost (which equals [(Capitalized Cost + Residual Value) x Money Factor]/12)
  4. Monthly Sales Tax Cost (assume 7% because the seller has to pay taxes & stuff)

Now the craziest part of this whole calculation is #3 because you are paying interest on not only the capitalized cost, or the 90% value of the car you haven’t paid for upfront but also the residual value of the car after 3 years, remember this was 57% based on our assumptions from above. So think about that with me – you are paying interest based on: 147% (90% + 57%) of the value of the car, even though you are also paying 10% downpayment. Ouch.

Now for the results:

Screen Shot 2015-11-11 at 10.33.58 PM

A lot of numbers to decipher through, but not surprisingly buying your cars for the next 48 years in cash is the cheapest method in terms of total cash spent. The only difference between the financing vs. cash method is the interest that you pay. Since we are financing each of our cars over 6 years, instead of paying for them up front in cash, the bank wants to be compensated via a healthy interest cost. Okay, makes sense.

But let’s now turn our focus on the total cash spent in the lease column. This column consists of three portions of cost. 1) the principal cost (10% down payments every 3 years) 2) the interest cost (remember that high multiple of car value you are paying – 147%) and 3) depreciation / other cost (the value of the car you use up in your lease + local sales tax). Hopefully you notice the total cash spent in the column is significantly higher. But I think it’s hard to quantify or really see the simplified meaning of this comparison in the above table. So consider the following:

Screen Shot 2015-11-11 at 10.45.45 PM

Over the next 48 years, in each buy method you will drive 7 total cars for 7 years each (7x cars driven multiple). In the lease method, since you are leasing a new car every 3 years you will drive a total of 16 cars (16x). But when we look at the cost of each method in something called the equivalent cars paid multiple – the results are STAGGERING. Over the same 48 year method, we are paying for an additional 5.7 cars or an additional $180K total cash spent by leasing cars vs. buying our vehicles in cash. By the way, we aren’t leasing anything that’s a nicer car, the base assumption was with the same purchase price!

So what’s the point & why the difference?

Some others disagree, but I still would argue it’s best to buy vehicles in cash (and for way less than $33,560 – by the way), but the point is even over a 48 year timeframe financing your cars isn’t too big of a deal (especially in a low interest environment). You are basically paying for an extra car over your lifetime (7.9x vs. 7.0x). Not ideal, but not a life-changer either, and not everyone has the circumstances to buy cars in cash. But by consistently leasing a car, you are committing financial suicide. It hurts big time because in a car lease you are paying for the depreciation of a car but you don’t get any of the benefit (because you don’t own it!) and you are paying massive interest costs (though they disguise it well).

On my local radio, when I hear a leasing commercial that says, “Lease your car, but drive it like you own it” it makes me want to punch my radio dial in the face. Ha, yeah right. Don’t do it. Don’t lease.

7 Comments on “Should I Buy or Lease a Car? – The Long-Term Solution

  1. This is an interesting article, and I’m inclined to agree with your conclusions, but what was missing from the piece was a discussion of maintenance and repair. Isn’t that a selling point for leases—most repairs are covered under warranty for 3 years? Statistically speaking, owning a car for 7 years at a time makes you more likely to have to pay for a major repair out of pocket. I don’t know if that would be enough to tip the scales in favor of leasing, but I do think it’s a consideration, especially if you end up with a lemon or a poorly designed car at some point.

    1. Thanks for stopping by. I thought about adding in a discussion on maintenance and repairs, but I think there are potential liabilities that go both ways, so I decided to exclude.

      On the Buy methods, we can assume years 1-3 are going to be similar to the lease (because of warranty), but maintenance would definitely be a factor in years 4-7. $180k is a heck of a lot of maintenance buffer though 🙂

      On the Lease method, insurance premiums could be higher as sometimes companies require greater levels of insurance on leased cars. Also, if we drove over the allocated mileage (usually about 12k miles per year) we could have additional costs, as well.

      Sounds like an idea for a follow-up in the future!

    1. I can appreciate your point of view, but for practical purposes I disagree. I am looking at the assumed lifespan of use for my cars.

      With that said, the numbers wouldn’t change much assuming you don’t trade in your cars every 3 years (I.E. take the extra value hit based on what the dealer gives) and instead sold at private-party value. Sure, we would have additional tax & fees to pay each three years, but in terms of the comparison to the cost of the leases ($180K delta), this cost would be negligible.

  2. Interesting post! I’ve never leased a car before, because I just had this inherent sense that it was a poor way to spend money, but the way they calculate the financing is very strange. I was surprised to learn about about the interest calculation portion. It didn’t make sense to me that they would charge interest based on the capitalized cost AND the residual value. I googled it, and it looks like the way that calculation is designed to work is that it roughly averages the difference between the capitalized cost and the residual value, to get a rough amount of interest that would be owed on the average principal amount financed, rather than calculating the precise number via an amortization schedule. I don’t quite understand how it averages those numbers, since I don’t see a “divided by two” anywhere in the formula, but that must be the point of that weird “money factor” number. Strange. I think it’s a sign that it’s a shady method of financing when you’ve got people with strong math skills scratching their heads.

    1. Thanks for stopping by and agreed, haven’t figured out the reason for the interest calculation either. Guess when you think about rule #1 for banks – there is a fee for that (everything), it makes sense.

  3. Put another way, in exchange for those lower monthly payments that come with a lease, you pay significantly higher finance charges compared to an equivalent loan, about $1,435 more for that $36,000 car.

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