Buying vs Leasing: Leasing Explained

Loans versus Leases -  Loans enable people to buy things.  A lease is a rental agreement.  Once you make all the payments on an installment loan, you actually own your car; whereas, when all the payments are made on a lease, you own nothing.  Before you lease, we STRONGLY suggest using a loan payment calculator so you know what the payment would be if you decided to finance (purchase) the vehicle instead of leasing it. You'll quickly see how changes in rate, purchase price, term, and down payment can effect loan payments. Those same factors will effect your leasing payments as well.

Who Should Lease? - Leasing began as an economical way to provide vehicles for business use. Today it's a way for private individuals todrive more car than they can afford.  A significant portion of the new Mercedes-Benz, BMW, and Lexus vehicles on the road are leased.  If you are a small business owner, or use your vehicle exclusively for business, leasing may be a good idea.   However, if like most Americans you can't deduct lease payments from your taxes, I can't recommend it.  As a rule, the cycle of ownership costs less than the cycle of leasing.  In other words, once all the fees are added up, you'll pay less to buy a new car you'll own than to lease a car you won't.

Dealers will tell you that a lease is good for people who want to drive a new car all the time.  Leasing also appeals when people want lower monthly payments and want to drive something they can't otherwise afford.  I say it's not worth it unless you have money to burn.  You have all the responsibilities of ownership with none of its advantages.  The vehicle is owned by the finance company, yet you are responsible for maintenance, repairs and insurance.  Leases limit the number of miles you can drive: if you drive over 15,000 miles a year, your odometer becomes a cash register for the finance company.  The only financial advantage of leasing for anyone (other than business use) is that state sales tax need only be paid once a month, as it's based on the amount of each monthly lease payment.  If you buy a car it must be paid all at once and is usually rolled into the loan.

New Problems For Potential Leasing Customers - Millions of car leases financed by banks are expiring just as domestic new car prices appear to be falling. In 1998 only 38% of lease customers turned in their vehicles at the end of the lease.  Due to aggressive pricing and rebates offered by domestic automakers that percentage has risen to over 56% this year and third party financiers (banks and finance companies) are panicking. The result is a gap between what banks expected the vehicles to be worth and what they're actually fetching at wholesale dealer to dealer auctions. In 2000 that gap cost banks about $2,000 per vehicle. This year (2001) losses are expected to rise to between $2,500 & $3,000 per vehicle. Major financing companies like GE Capital and First Union have eliminated their leasing programs altogether while Chase, Bank of America, and Bank One are significantly scaling back their operations. For the leasing customer the result is that fewer banks are willing to lease, and the cost of the available leases is significantly higher.

In the past, car dealers could chose between four or five different leasing sources. The current situation limits their choices to one or two and the manufacturers own leasing programs offer better prices than the third party resources that remain. The reason is that the manufacturer's financing companies (Ford Credit - GMAC - DC Credit) aren't suffering nearly as much because their leasing losses are offset by the profits made when the vehicle was sold initially. Losing money on lease turn-ins is seen as a normal part of doing business for the Big Three.

Leasing's Hidden Costs - Your contract outlines the condition a vehicle must be in when you return it.  Dings and scratches must be professionally repaired, broken cup-holders must be replaced, cigarette burn-holes must be eliminated, all 4 tires must match.  You will be charged list price for any repairs or replacements, in addition to your termination (vehicle return) fee.  Things you might never repair if you owned the car may have to be fixed before the end of the lease. 

A Lease Is A Contract - Basically a lease is a contract in which monthly payments are made to a leasing agent in exchange for the use of the vehicle for a predetermined (24, 36, or 48 months) amount of time.  Unlike financing, where the payments are based on the entire cost of the vehicle, lease payments are calculated to cover only the estimated amount of depreciation, plus interest. You're only paying for the depreciated (used up) portion of the car's original value, not the entire selling price.  It's comparable to renting an apartment instead of owning a house.  

Early Termination - Salespeople may tell you it's easy to end the lease before your contract expires, but don't believe them.  A leasing contract is difficult and expensive to terminate early.  Your credit will be ruined, and you can be sued for breach of contract if you don't pay the stiff penalties assessed.  There are lots of customers driving unwanted leased cars they can't afford to turn back to the bank.  Dealers will gladly pay your penalties and buy you out of your current lease, but the premature turn-in fees ($1000 or more) will be added on to your new loan or lease payments.  Don't even think about leasing unless you can keep a vehicle for the entire term of your contract.

Negotiate For the Car and Financing Separately - Negotiate the price of your car separately from your leasing arrangements.  A lease is a different commodity from the car.  Just as you would with a loan, find your financing before you enter into negotiations with the dealer.  And don't reveal that you intend to get your leasing elsewhere until you've finalized the vehicle's price.

Manufacturer's Rebates - Before you go shopping, find out if there is a rebate on any of the models you're looking at.  (See Step 6.)  If you go through a third party leasing company (e.g. GE Capital, Chase, or Nation's Bank), the rebate will be applied to your down payment.  If you go through a manufacturer's leasing subsidiary (e.g. Ford Credit, GMAC, Mercedes-Benz Credit), the rebate is typically added to the residual value of the vehicle.  Either way, you get the rebate, either at the beginning of the lease or at its end.  Beware of unscrupulous dealers, who might try to tell you that leases don't qualify for the rebate.  Rebates apply whether you're buying or leasing.

A leasing deal with a rebate should be written as follows: the dealership adds up the negotiated purchase price, applicable taxes, license fees, document fees, etc. into a grand total, the capitalized cost.  Then your capitalized cost reduction (down payment), including the rebate and any cash you submit, is subtracted from the capitalized cost.  The resulting balance is your gross capitalized cost.  Your lease payment is determined by the difference between the vehicle's residual value and the gross capital cost.  A lower gross capital cost means a lower monthly payment for you.  Make sure the rebate goes from the factory to you, not from the factory to the dealer.

How's Your Credit? - If you have no idea what your credit report shows, now is the time to order a 3-bureau (TRW, Equifax, & TransUnion) credit report. See what's in your report before you speak to any car dealer or financial institution.  Many people don't know what's on their credit report, but don't be surprised if your car dealer has seen it.  Lenders determine the credit of a prospective borrower using data obtained from TRW, Trans Union, and Equifax.  Consumers receive an  A, B, or C grading based on their income, credit history, and previous debt experiences.  A-rated borrowers, the VIPs of the financial world, get the lowest rates and typically qualify for most leases.   B- and C-rated borrowers are not considered bad problems anymore and can usually buy a vehicle with a substantial down-payment or co-signer. However B- and C-rated borrowers rarely qualify for a lease without a very large downpayment.  

The Money Factor - Money factor is a purposely confusing term for the calculation of the interest portion of the monthly payment in a lease; the number must be multiplied by 2400 to get the annual percentage rate.  The lower the risk for the lessor (meaning the better your credit rating), the lower the money factor. 

Used Car Leasing - Since the majority of depreciation occurs during the first 18 months of a vehicle's life, used-car leasing makes more sense than new-car leasing.  You save money because the lease payments are based directly on the amount of depreciation that occurs during the term of the contract.  Lenders, however, consider used vehicles more of a risk than new vehicles and often charge a higher money factor (interest rate) to lease them.  Used-car leasing began with a handful of manufacturer-driven lease programs on some high-end luxury cars and SUVs.  It now accounts for over 15% of all automobile leasing activity, and the amount is growing every year.  Manufacturers see it as a profitable way to unload the millions of vehicles returning from new car leases, as they get to lease the same vehicle twice.

Make sure to find out the cost of leasing the same model new before considering a used-car lease.  A vehicle 24 to 36 months old is your best candidate.  Look for low-mileage vehicles, as their residual value will be higher, keeping your monthly payment lower.  The devaluation of a vehicle accelerates as it reaches its 5th birthday, so keep the lease to two or three years max.  It's also wise to see if an extended warranty applies.  If not, consider a term equal to the length of your lease, or get the dealer to offer you an extended warranty at a discount.

Residual Value - A car's residual value is the largest contributing factor to the cost of a lease.  Residual value is the amount it will be worth at the end of the lease.  Depreciation is the difference between the selling price and the residual value estimated by the leasing company, expressed as a percentage of Manufacturer's Suggested Retail Price ( MSRP).  If the market likes a vehicle (for example the Toyota Avalon, Ford Explorer, Lincoln Navigator, Honda CR-V), it will have a higher than average residual value.  Cars with lower perceived values (Contours, Metros, Neons, and most Hyundai's) have low residual values.  Lessors use ALG (Automotive Lease Guide) residual guides to determine the value of vehicles 24, 36, 48, and 60 months old.  Before you lease, check out the residual values of the cars you're considering at the Edmunds and Kelley BlueBook websites.  Your bank or credit union may have a copy of the Automotive Lease Guide, which reviews residual values in greater detail.  Usually depreciation eats up 20-30% of a vehicle's value during the first year, and another 15% during the second.   In general, lower depreciation gives a higher residual value, which means a lower monthly payment for you.

A vehicle's perceived value leads directly to its wholesale (dealer-to-dealer) auction value.  In an effort to move more new cars into the market, some new-car manufacturers subsidize artificially high residual values in order to offer low monthly lease payments.  Ford Credit reportedly lost millions of dollars on early groups of Ford Tauruses and Contours coming off lease. The flooded marketplace reduced their wholesale values to the point where the vehicles were worth markedly less than their original residual estimates.  If the residual value estimate is too high (as in the case of Ford), the lessor loses money because the lease was structured to repay a set amount of depreciation.  Don't hold your breath, Ford isn't going to make the same mistake twice.

Closed-End And Open-End Leases - In a closed-end lease, the residual value is pre-determined.  At the end, you pay for any extra mileage or damage you put on the vehicle.  With an open-end lease, the residual value is determined when you turn the car in at the end of your contract.  If it's worth less than the originally-estimated residual, you come up with the difference.  If it's worth more, the leasing company pays you the difference.   You still pay for any extra mileage and damage.  Don't count on a check at turn-in time; there's a good chance you'll have to come up with additional cash instead.  For this reason I don't recommend open-end leases, even though the monthly payments may be lower.

Read The Lease Contract - Stop by some dealerships and private leasing companies and obtain a few blank leasing agreements (some dealers won't give you one, so keep trying).  Each leasing company will have their own customized contract, and you'll need to read each one.  If you have trouble reading small print, now is the time to buy a magnifying glass, you'll need it.  Most contracts forbid travel out of the Continental US, while others may limit interstate travel.   Some contracts require more insurance than normally required in an installment loan agreement.  Take a look at a Mercedes-Benz Credit leasing agreement.  If all leasing contracts looked like this, most leasing fraud would be eliminated.  If you're unsure of any terms or legal language, ask your accountant or attorney to review the contracts with you; don't get your legal advice from a salesperson.  Thousands of dollars can be lost by misinterpreting a term or calculation contained in the contract.  A hundred dollars spent on legal advice at this time can buy you peace of mind for the duration of your contract.  You'll be wise to develop your own basic knowledge of leasing contract terminology, calculations, and fees.

Anticipate Fees - Many advertised leasing deals require substantial capital cost reductions (cap reductions, or down payments) in order to get the advertised monthly payment.  Most don't include your inception fees or your sales tax, and you'll almost never see the money factor (interest rate) shown.  Don't fall for the "0 DOWN" come-on.  Don't think for a minute that the dealer or leasing company is absorbing your acquisition costs.  A cap reduction may not be required if you have spotless credit.  But the inception fee and other dealer charges like tags and registration will be expected.  Find out what fees you will owe at the end of the lease before you sign.  Ask the dealer what charges are involved in early termination.

Gap Insurance - Gap insurance covers situations such as the theft or totaling of the car and you end up owing more on the lease than what the car is worth. Standard insurance will pay up to the car's current value, perhaps even the replacement value. But if what is owed is more than that, you still have to pay the difference. Gap insurance will do this for you.  As with all insurance policies, ask your personal insurance agent, not the dealer's leasing manager, for a quote.

What You Want to See Before You Sign -  Review the current rates, terms, and monthly payments before going to the dealer.  (See the Leasing Information Resources Section.)  Make sure you see the negotiated capitalized cost (selling price) and any deposits or trade-ins reflected on the dealer's lease worksheet.  Make sure the terms and monthly payment match what is on your lease contract.  Check for hidden charges contained in the contract that have not been discussed.  Find out what the early termination fee is, and make sure you're charged no more than $200 for your inception fee.  By law the dealer must show you all of his calculations.  If he won't, assume you are being scammed and leave.  Too many people are only concerned with their monthly lease payment and never question the dealer's calculations.

Answers to Commonly Asked Leasing Questions are on the next page>