What's the difference between a car loan and car lease? Here are 6 tips to know which option is best for you.
For many people, the cost of financing or leasing a vehicle is one of your largest monthly expenses. Unless you live in a city with easy access to public transportation or have plenty of ride sharing services, you probably need your own vehicle to get to work, run errands, and have fun.
But choosing whether to get an auto loan, a lease, or to pay cash for a vehicle can be confusing. Having a monthly payment can also become a huge burden if your financial life takes a turn for the worse.
A Money Girl listener named Diana G. is in this camp. She says, “I have an auto loan that I can no longer afford. Since I’m upside down on the loan by over $8,000 and can’t trade in the vehicle, what are my options?”
In this post, I’ll answer Diana’s question, explain the differences between financing and leasing a vehicle, and cover six tips to know which option is best for you.
How Buying a Car with a Loan Works
When you purchase a vehicle with an auto loan you make fixed monthly payments, including interest, over a set amount of time. In some cases, an auto dealer or lender may not require a down payment; however, the more you pay upfront, the lower your debt and payments will be.
For example, if you buy a new car for $30,000 and make a 20% or $6,000 down payment, you make up the difference by financing $24,000. Your monthly payments are determined by the interest rate and length of the loan. Other factors include whether you buy a new or used vehicle, the price, your credit, and how much you earn.
While a lower monthly payment always sounds good, the longer your repayment term, the more interest you pay over the life of the loan.
Diana didn’t mention the details of her loan, but let’s say she borrowed $24,000 at a 4% APR (annual percentage rate). For a 3-year loan, her monthly payment would be $708, and a 6-year loan would be $375.
While a lower monthly payment always sounds good, the longer your repayment term, the more interest you pay over the life of the loan. Plus, longer auto loans make it easier to get “upside down,” which is the situation Diana said she’s facing.
Being upside down is financial jargon that means you owe more than the underlying asset is worth. So, if you get into a situation where you need to sell the car or make an insurance claim because it gets stolen or totaled in an accident, you might not receive enough money to pay off your loan in full.
When you’re dealing with a potential buyer or an insurance company, they only pay market value for a vehicle, even if it’s less than what you owe for it. To pay off your loan, you’d have to make up the difference from savings—that’s a bummer.
Although we need vehicles, they’re typically terrible investments because they depreciate very quickly. New cars can lose as much as 25% of their value after just one year. That’s why used or pre-owned vehicles make a lot of sense; the first owner takes the biggest depreciation hit.
The best way to prevent being upside down on a car loan is to make as big a down payment as possible, so you have equity in the vehicle. Plus, paying more upfront increases your ability to get approved for a loan at the lowest interest rate, which reduces your payments and cuts your interest expense.
Another way to borrow less for a car is to trade-in your current vehicle—if the dealer will offer you a fair value. The trade-in value is deducted off the purchase price of a new or used vehicle.
When buying a car, make a goal to pay at least 20% of the purchase price, including any trade or promotional rebate, to get the best deal. And do your homework before stepping on a car dealer’s lot. Know the purchase price of the car you want, the value of any trades or rebates, the amount of cash you can put down, and the monthly payment you can afford.
At the end of the article I’ll offer advice on what to do when you need to get rid of a vehicle with a loan or lease that’s putting a tight squeeze on your finances.
How Leasing a Car Works
A third of new car and truck transactions in the U.S. are leases, which can be attributed to the soaring cost of vehicles. A car lease is a contract that allows you to use a vehicle over a set amount of time.
Unlike with a car loan, you should pay as little down as possible with a lease, since you never build equity in a lease deal.
Your lease payments compensate the dealer for depreciation that will occur during your lease term, plus additional fees that give them a profit for making a deal with you. There’s typically a down payment due at a lease signing, such as 10%.
Unlike with a car loan, you should pay as little down as possible with a lease, since you never build equity in a lease deal. In other words, only pay the minimum required amount upfront. Also, it’s best to lease new vehicles only for a term that doesn’t extend beyond the warranty period.
Let’s say you lease a $50,000 car that will be worth $20,000 in three years when your lease expires. This $30,000 in depreciation, less any trade in or down payment, plus dealer fees, is the basis for the calculation of your monthly lease payments. That’s why lease payments can be much lower than loan payments for the same vehicle. Instead of paying for the entire car, you only pay for the estimated depreciation of the car during the time you lease it.
There are multiple factors that go into the calculation of a monthly car lease payment including the term (such as three or five years), the retail price of the car, your down payment, credit rating, depreciation, dealer fees, and state and local taxes.
Different makes and models of cars have very different depreciation rates. Those that depreciate the least are the best to lease. To research vehicle prices and depreciation rates, check out TrueCar and Edmunds.
Different makes and models of cars have very different depreciation rates. Those that depreciate the least are the best to lease.
At the end of the lease term you can return the car or purchase it at a pre-determined depreciated value, which is known as the residual value. The higher the residual value, the more it’s worth at the end of a lease and the lower your lease payments will be.