By Bruce R. Kuhlman, PhD, CFA, CAIA, Full-Time Faculty, Purdue Global
Published January 2016
You find that you need a car, but should you lease it or buy it?1 To get to the heart of that question, you first need to know the mechanics of leasing. Perhaps you have had a salesperson ask, “Why pay for the whole car, when you can pay just for the portion you use?” That question seems logical and enticing, but it is also somewhat misleading.
Ignoring the relationship between the dealership and the manufacturer, there are three main characters in an auto lease: the automobile dealership, the lessee, and the lessor. The lessee is the individual taking possession of the vehicle and paying the lease payments. The lessor is the financial institution that provides financing for the lease and receives the lease payments. The dealership provides the showroom and handles the paperwork. This is important...you do not lease the car from the dealership. You lease it from the financial institution. The financial institution can be a bank, a credit union, or the financial subsidiary of the auto manufacturer.2
Here is the heart of a lease that most people don’t fully understand. The lessor effectively purchases the car from the dealership and then rents it to the lessee. In other words, the lessor, by providing the purchase price of the auto, has committed its funds to the transaction. In return the lessor expects to receive a return on the total amount provided, not just “the portion you use.”
The Lease Payment
The amount of the monthly lease payment depends on the interest rate,3 the price of the car, the length of the lease,4 and the residual value. The effects of these factors are most easily seen in a simple numerical example. We will use a 36-month, 5% lease on a $40,000 vehicle with a 55% residual value ($22,000). The thirty-six monthly payments on a lease, assuming no down payment, would be $631.14.5 With a 6% sales tax, the monthly lease payment comes to $669.00. If the individual instead purchases the car, all sales tax is charged at the date of sale. Financing $40,000 + $2,400 tax for 3 years at 5%, the payment is $1,270.77.
The lease payment is considerably less than the purchase payment, because the lessee repays (finances) the difference between the price of the car and the residual value, in this case $18,000, and pays only interest on the $22,000 residual value. In other words, the lessee is obligated to pay the lessor $18,000 plus interest over the 36-month term of the lease6 and a balloon payment of $22,000 at the end of the lease. Because the residual value is the agreed upon value of the vehicle in 36 months, the lessee can simply return the vehicle to satisfy the balloon payment or pay the $22,000 (plus tax) and keep the vehicle. The critical fact ignored by most lessees, is that, although the lessee only pays off the $18,000 decrease in value of the vehicle, each monthly payment also includes interest on the $22,000 residual value.
A strong motivation for leasing is that the individual is able to drive a $40,000 vehicle for a monthly lease payment of $669.00. This payment would only purchase a vehicle worth approximately $22,322.
Now that you know the mechanics (the mathematics) of leasing, should you lease or buy? Unfortunately, the answer is a resounding, yet confusing, yes! That’s because the question isn’t easily answered by looking only at the numbers. Let’s compare some of the factors considered in leasing or purchasing a vehicle:
|Initial Payment||Often “nothing down.” As incentive, the first month’s lease payment is often waived.||Variable.|
|Amount financed||The difference between the selling price and the residual value.||The price of the car plus sales tax.|
|Overall financing cost||Pay for the “portion you use” plus interest on the residual value. This enables the lessee to drive a more expensive car than possible with a purchase.||Pay the entire price of the car plus interest.|
|Taxes||Sales tax is paid on each monthly payment.||Sales tax added to the purchase price at time of sale.|
|Maintenance*||Often included in the lease.||Manufacturer’s warranty only.|
|Price of the vehicle driven for the same monthly payment||$40,000||$22,322|
|Value at the end of payment||$0. The lessee must lease or purchase another vehicle.||You have a car and no lien. The value of the car is approximately the residual value in the lease.|
* Maintenance costs vary by manufacturer and may or may not be included in the initial warranty.
The weights of these factors in the lease vs. buy decision vary. For example, individuals may not even consider factors 4 and 5, taxes and maintenance. Factor 1 is critically important, but most auto manufacturers frequently have “zero down” offers known as “sign and drive” for leasing or buying. Factors 6 and 7 are also important, as the decision often boils down to driving a fancy new car every three years or driving a less fancy car now and at the end of the lease. At this point the driver has a used car to drive, where re-leasing would provide a brand new, more expensive car.
So, what is driving the proliferation in auto leasing? What should be fairly obvious is that the numbers alone don’t answer that question. The answer must lie in some combination of costs and satisfaction (emotions) and will be addressed at a later date.
Bruce R. Kuhlman is a professor at Purdue Global. The views expressed in this article are solely those of the author and do not represent the view of Purdue Global.
1 Leasing should be considered a form of financing. As with a financed purchase, a financial institution has a lien on the vehicle until the contract is settled.
2 Through financial subsidiaries, most auto manufacturers now offer financing for purchases and leases.
3 The interest rate on a lease, as with a purchase, is determined by factors such the credit worthiness of the lessee (or purchaser) and the length of the agreement.
4 The interest rates on leases, as with mortgages and other loans, typically increase with the maturity of the agreement.
5 This and all other calculations are available upon request.
6 Each monthly payment on the $18,000 includes principal and interest. This is equivalent to a fully amortized loan of $18,000.