Economics Behind Buying versus Leasing a Car

Chandra M. Kala

 

MGMT 6300 – Business Economics

Submitted on December, 22 2002

Professor: Dr. James Stodder

Table of Contents

1. Abstract

2. A Personal Story

3. Definitions

4. Advantages/Disadvantages of Leasing and Buying

5. A Financial Model

6. A utility Model

7. Things to Consider

8. Conclusion

9. References

 

Should I buy or should I lease? This question comes in most of the consumers mind when they look for a new car. Recently, I was facing the same dilemma when I was looking for a new car. I was getting different opinions from different resources. Finally I bought the car in place of leasing it. I feel that I made the right choice. In my opinion buying a car is better than leasing a car. I do make this statement but a question is always there in my mind “Could I have got a better/safer car if I would have leased the car?”

 

Most financial advisor would agree that it is wise to lease a commodity that depreciate and wise to own or purchase a commodity that appreciates. Is this statement true for cars also? We all know that the cars loose good amount of their value as soon as they are out of the lot.

 

In this paper I would like to discuss the general concept of leasing a car, economics behind leasing and buying a car, advantages and disadvantages of these two options, and finally I would like to build two models, one financial and one utility, to compare and measure these two options. I hope by doing this I will be able to prove my point (and I will convince myself) that buying a car is better than leasing a car.

 

 

 

In July 2002 I was involved in an accident. Fortunately nobody got injured but my car was totaled. Before the accident I had 98 Mazda Protégé. After the accident, I thought that I should buy a little bigger and safer car. For me, choices were obvious, Honda – Accord, or Toyota – Camry. But one of my friends suggested me to buy Saab – a much safer and better car (in his opinion). He also told me that Saab is having a very good deal on their leasing program. I decided to go to a Saab dealer. I really liked Saab 9-5 sedan but sticker price, $39,000 was little too high for my pocket. When I asked the sales person that how much it is going to cost me to lease the car, and what are the advantages of leasing the car, he gave me the following pitch:

 

With $2,000 in cap cost reduction, $650 security deposit, $550 acquisition fees, and $350 disposition fees; you just have to pay only $490 + tax a month to lease a Saab 9-5 sedan for 39 months. Residual value of the car after the leasing period will be $21,500 and your mileage limit will be 12,000 miles per year. Our Money Factor on lease is 0.001950.

Because of such a special leasing deal, leasing a car is much better option than buying a car. To buy the car, if you are paying $4,300 in down payment (same as your first payment when you are leasing the car) you have to take a loan of about $37,000. With 6.5% APR your monthly payment will be $725.

When you are leasing the car you will not only be paying less as your monthly payments but your overall cost will also be less. You will also get the choice to buy the car at residual value after the leasing period is over. Then you can finance the residual amount to buy the car. It is a win-win situation for you.

 After hearing sales person’s pitch I was confused. I did not know lot of terms what he was using, and I was not convinced that leasing a car will be cheaper than buying a car. I did not have enough time to research, so quickly I made my mind and bought Honda- Accord.

During the Business Economics class I got the opportunity to choose my own topic for the term paper and I felt comparing leasing and buying options may be a good topic to research.

Lets see whether my decision to buy Honda Accord was the right choice or not!

Before I go any further let me define some of the common terms used in the car leasing industry.

 

 

As a general concept, leasing can provide you more car (upgraded models, more attractive and practical options) for a lower monthly payment than if you were purchasing a vehicle. The reason that this is possible is that when you lease a car, your payment is based upon your usage of the vehicle and not on the entire cost of the car. But at the end of the lease period you have no equity in the car.

Capitalized (Cap) Cost

The Capitalized Cost is the total value of the vehicle at the inception of the lease. If you were purchasing the vehicle, this would represent what you are paying for the vehicle. The Cap Cost will effect your monthly payment. It is negotiable and should always be fully negotiated!

Capitalized (Cap) Cost Reduction

This is equivalent of down payment. A payment used to reduce the cap cost. You have to pay this money at the lease signing time.

Residual Value

The Residual Value is what the lease company projects will be the value of the car at the end of the lease term. Remember, you are only paying for the time that you use the vehicle. A higher Residual Value usually results in lower payments and you will probably turn the vehicle in at the end of the lease term. A lower Residual Value means higher payments but probably some equity in the vehicle at the end of the lease. If you are planning to buy the vehicle at the end of the lease then a lower residual value would be the better option.

Money Factor

Money Factor is a number that determines the monthly finance cost of a lease. It represents the cost of money and can easily be translated into an interest rate. By multiplying the money factor by 2400 you can determine the interest rate. i.e. money factor 0.002055 will be equal to 4.93% (0.002055*2400).

Inception Fees (Acquisition Fees)

Inception Fee is a charge for filling out and processing the lease paperwork.

Disposition Fees (Termination Charges)

Disposition Fees is charged at the end of the lease. It covers turn-in, removal, and auction expenses.

Term

Term is the length of the lease in months. For a 39 months lease, you have to make 40 payments, 1^st payment at the signing of the lease and then additional 39 payments.

Up-Front Cost

Buying a car requires a down payment — plus sales tax, licensing and registration fees, and any miscellaneous fees that the dealer may impose. Leasing a car usually has lower up-front costs. These include capitalized cost reduction, inception fees, disposition fees, the first month's payment; taxes and registration fees; the same pesky miscellaneous dealer fees; and a security deposit, which is refundable when the lease ends.

Mile Limitations

Most lease programs have strict limitations on mileage. Depending on your contract it is usually between 12,000 and 15,000 miles annually. Driving over the allotted miles will result in additional charges when the lease ends.

Closed End Lease

This is the most common type lease used by the consumers. In this type of lease the residual value of the car is determined at the beginning of the lease. At the end of the lease, if vehicle's value falls below the residual value, it is the lease company that eats the excess depreciation.

Open End Lease

In this type of lease the residual value is not calculated until the end of the lease. For this type of lease, customer set the value at the beginning of the term, but, unlike the closed end lease, customer pays extra if the car is worth less at the end than the price customer had set at the beginning. Conversely, if it worth more, individual would get a rebate. This type of lease usually has lower monthly payment than the close end lease because customer is taking extra risk at the end of the lease.

Gap, or Gap Insurance

The Gap Insurance is a specific insurance that pays off the lease company in the event that the car is totaled or stolen during the lease term. It is smart to insure against this "gap" because when a car is totaled or stolen, the lease becomes an early termination, and the charges for terminating a lease can be significant. Most insurance policies are set up to pay only the market value of the vehicle when calamities like these occur, so without having gap insurance you may find yourself without a vehicle and owing significant money to leasing company.

Sales Tax Savings

When leasing, instead of paying sales tax up front, each monthly payment is taxed, as opposed to paying a lump sum on the entire value of the vehicle when you purchase.

 

 

Advantages of Leasing

• Usually you need less up-front money to drive car away.
• You only pay for depreciation during the term. Your monthly payments are 30%-60% lower than a purchase loan.
• Since monthly payments are lower, you get more car for your money and drive a new car every two to three years.
• Lower monthly payment, but not necessarily lower total costs.
• It is a form of "off-balance sheet" financing, so it may not add to your borrowing maximums for other loan qualifications.
• The higher the cost of the car, and the higher the business use percentage, the greater the tax advantage may be under certain circumstances.
• At the end of a close end lease, there is no hassle trying to get rid of a used car.
• If you are first time buyer or have bad credit, leasing may be an easier option than buying a car.
• If your lease term coincides with the manufacturer’s warranty, major repairs are always covered hence you have fewer maintenance headaches.

 

Disadvantages of Leasing

• High insurance cost - leasing company requires you to have insurance policy with higher limits.
• Many times you don’t get the appropriate rebates or reduction in MSRP when you are buying a car.
• Sometimes dealers can lie about the money factors and other costs associated with the leasing.
• Usually long term cost of leasing is more than buying. If dealer is showing that leasing is cheaper than buying then check their numbers very carefully.
• Penalties of terminating the lease during the leasing term can be expensive.
• Leasing limits you to 12,000 miles per year. Cost of driving the car beyond the allowed miles can be very high.
• Excess wear and tear clause can cost you decent some of money if you haven’t maintained the car during lease period.
• All four tires must match – this condition is in every lease contract. If the tires don’t match then leasing company will change all four tires and they will charge you MSRP of the tires.
• Too much fraud and unfair selling practices. Because most of the people don’t understand how leasing work companies play unfair games in leasing contracts.

 

Advantages of Buying

• Car has a residual value to you after a time. If you want you can sell the car.
• No restrictions on how many miles per year you can drive it, but with high mileage market value of the car will reduce.
• No insurance problems associated with a "premature" termination.
• If a home equity or investment-type loan is used to finance, the interest charges may be deductible on your tax return.
• You can treat the car any way you wish.  No turn-in problems with arguing over residual value.

Disadvantages of Buying

• Monthly loan payment will be higher.
• If you don’t like the car or car gives you lot of trouble then changing the car is not easy.
• If your car is totaled during the first year or two you may be a big looser even though you have the appropriate insurance.
• You may get bored driving the same car for a long time (10 to 12 years).

 

 

 

The financial model compares the financial obligations of car leasing and car buying options and suggests the better option for the given circumstances (parameters).

The model has five worksheets - Instructions, Leasing, Buying, Depreciation, and Comparison and it expect users to follow the worksheet in this order.

The model is not tested for the extreme values. It is expected that the users will provide appropriate and meaningful values.

 

Item	Type1	Details/Math behind the value
Leasing
Selling Price (SP)	US	Selling price of the car. This should be negotiated as much as possible in both of the options.
State Sales Tax	US	Sales Tax
Cap Cost Reduction	US	It is the money you are paying upfront to reduce the car leasing cost (i.e. down payment)
Security Deposit	US	Security deposit. You will get this money back after the leasing period is over. Try to put as little money as possible as security deposit.
Acquisition Fees	US	Charges for filling out and processing the lease paperwork.
Disposition Fees	US	Covers turn-in, removal, and auction expenses.
Initial Setup Charges	CA	Cap Cost Reduction + Security Deposit + Acquisition Fees + Disposition Fees
Tax on Initial Setup Charges	CA	Sales tax rate * Initial setup charges
Total Initial Setup Charges	CA	Initial setup charges + Tax on initial setup
Residual Value	US	Value of the car after leasing period is over. Higher residual value will produce lower monthly payments. If you want to return the car after leasing period, choosing a higher value is favorable.
Lease Duration	US	Duration of lease in months. 39 months is the most common duration.
Allowed Miles per Year	US	Allowed miles per year before any penalties.
Per Mile Charges Over the Limit	US	Per mile charges over the limit. Industry average is $0.18
Monthly Payment	US	If you know the monthly payment on lease, you should enter it in this field.
Money Factor	US	Monthly financial cost of the lease. Multiplying this number by 2400 gives the interest rate. Monthly payment will depend on the money factor value.
Interest Rate on Lease	US	Interest rate. Money factor can be calculated by dividing this number by 2400.
Lease Charges	CA	Monthly payment on a leased car has two components: Lease Charge Depreciation Charge   Lease Charges = ((Selling Price – Cap Cost reduction) + Residual Value) * Money Factor
Depreciation Charges	CA	Depreciation Charges = ((Selling Price – Cap Cost Reduction) – Residual Value) / Lease Duration in months
Monthly Payment (Before Tax)	CA	If user has specified the monthly payment then the value is copied here, otherwise monthly payment is calculated by adding lease charges and depreciation charges.
Tax on Monthly Payment	CA	Tax Rate * Monthly Payment (Before Tax)
Monthly Payment (After Tax)	CA	Monthly Payment (Before Tax) + Tax on Monthly Payment
First Payment	CA	= Cap Cost Reduction + Security Deposit + Acquisition Fees + Disposition Fees + 1st Month Payment
Total Money Paid for lease	CA	= First Payment + Lease Duration * Monthly Payment – Security Deposit
Buying
Selling Price (SP)	CO	Selling price of the car. Copied from Leasing worksheet
State Sales Tax	CO	Sales Tax. Copied from Leasing worksheet.
Tax on Selling Price	CA	Selling Price * Sales Tax rate
Selling Price (After Tax)	CA	Selling Price + Tax
Down Payment	US	Model provides the suggested value for the down payment. The suggested value is same as the first payment value calculated in the leasing option. Choosing the suggested value as the down payment makes the comparison easy (more accurate) of leasing and buying options.
Loan Amount	CA	Selling Price (After Tax) – Down Payment
Interest Rate on Loan	US	Interest Rate on Loan
Loan Duration (in months)	US	Duration of loan. The most common value is 60 months. For the model to work, this duration has to be equal or more than the lease duration.
Monthly Payment	CA	I used the PMT function to calculate the monthly payment. =ABS(PMT(Interest Rate/1200, Loan Duration, Loan Amount))
Total Money Paid	CA	= Down Payment + Monthly Payment * Loan Duration
Expected Average miles per Year	US	Expected average miles per year on the car. This is the industry average not the number of miles an individual will put on his/her car. The idea behind this number is that if you are driving more miles than specified here then you will have additional depreciation on your car due to the high mileage on the car.
Additional Depreciation cost per mile	US	Additional depreciation cost per mile for every mile you drive over the expected average miles per year. Industry average is $0.065 per mile. I calculated this value through Kelly’s Blue Book value software by changing the miles on many used cars and comparing the result on their market values.
Depreciation
Selling Price (SP)	CO	Selling price of the car. Copied from Leasing worksheet
Salvage	US	The value of car at the end of its useful life. By checking and comparing the depreciation of many cars through software available at www.leasecompare.com, my suggested industry average value for salvage is 0.095*Selling Price
Useful Life	US	Useful life of the car in years. Industry average is 12 years.
Depreciation of Car	CA	Depreciation of car is calculated via Double Decline Balance Method (function DDB) and Fixed Decline Balance Method (function DB). My suggestion is to use the Fixed Decline Balance method because it is providing better values for depreciation of car. Depreciation of car for the leasing term is calculated by: DB(Selling Price, Salvage, Useful Life*12/Lease Duration,1) i.e. SP = $43,000  Salvage = $4,085 Useful Life = 12 Years, Leasing Period = 39 months Depreciation in 39 moths will be DB(43000,4085,12*12/39,1)
Market value of Car	CA	Market value of car after lease term. =Selling Price – Depreciation of Car
Comparison
Yearly expected Miles on the Car	US	How much miles individual is planning to put on the car in a year? Putting lot of extra miles (miles over the allowed limit) on a leased car will increase the cost of the lease.
Three situations are compared
Choice 1 – Returning the leased car after leasing period
With Lease Option
Lease Expenses	CO	Total money paid for lease. Calculated in the Leasing worksheet.
Charges for extra miles	CA	If yearly expected miles on the car is more than the allowed mileage limit (captured in Leasing sheet) then charges for extra miles = (Yearly expected miles – allowed miles) * per mile charges over the limit
Total expenses	CA	Lease expenses + charges for extra miles
With Buy Option		To compare the lease option with the buy option I will assume that in buy option we are selling the car at the same time when we are returning the car in the lease option. I will compare the money spend in both the options to judge which option is better. When I am selling the car I am depreciating the car value as calculated in the depreciation worksheet.
Down Payment	CO	Down Payment from the Buying worksheet
Monthly Payment	CO	Same as monthly payment calculated in the Buying worksheet
Total Money Paid	CA	This is the total money paid in down payment and monthly payments in the duration equal to lease duration.  i.e. if we are leasing a car for 39 months and comparing it with the buying option where we are taking the loan for 60 months. Lets say that our down payment was $5,000 and our monthly payment is $800 then Total Money Paid in 39 months with buy option will be 5000+800*39
Money Paid toward principal	CA	Out of total monthly payments how much money is paid towards principal. I calculated this value by using CUMPRINC function.
Total Depreciation of the car	US	Model suggests the depreciation value of the car as calculated in the Depreciation worksheet. If user wants he/she can overwrite this value.
Depreciation due to extra miles	CA	If individual is putting more miles than expected (as specified in the Average Miles per Year column in Buying worksheet) then car will have extra depreciation due to high mileage. This is calculated by multiplying extra miles by additional depreciation cost per mile.
Present Market Value of Car	CA	This is calculated by subtracting total depreciation of the car and depreciation due to extra miles from the sale price of the car.
Amount Left in Loan	CA	= Total loan amount – Money paid toward principal
Total Expenses	CA	= Total Money Paid – (Present Market Value of Car – Amount Left in Loan)
Conclusion:		If Total Expenses in leasing the car is more than Total Expenses in buying the car then buying is a better option otherwise leasing is a better option.
Choice 2 – Buying the leased car after leasing period		Extra miles on the car will have no effect in this comparison because you are buying the car after lease period hence there is no penalty for the extra miles on the car.
With Lease Option		In my model I am assuming that after the leasing period, the remaining amount is financed in place of paying it directly from your pocket.
Total Money Paid during lease	CO	Total money paid for lease. Calculated in the Leasing worksheet.
Residual Value	CO	Residual value of the car after lease period. Copied from the Leasing worksheet.
Loan Amount	CA	You have to take the loan of this amount. This amount is same as the residual value of the car.
Loan Duration	CA	Duration of loan in months. It is calculated by subtracting the lease duration (Leasing worksheet) from loan duration (Buying worksheet).
Interest Rate	US	APR for the new loan.
Loan Pay-off value	CA	Loan pay-off value, calculated by using PMT function.
Total Expenses	CA	= Total Money Paid during lease + Loan Pay-off value
Total Expenses	CA	Lease expenses + charges for extra miles
With Buy Option
Total Expenses	CO	Same as the Total Money Paid field of the Buying worksheet.
Conclusion:		If Total Expenses in leasing the car is more than Total Expenses in buying the car then buying is a better option otherwise leasing is a better option.
Choice 3 – Unfortunate Event, when you totaled your car during leasing period		In my model I am not considering the effect of reimbursement money received from the insurance company for your totaled car. I am assuming that consumer has GAP insurance if (s)he is leasing the car. In buying case I am assuming that the consumer will get the fare market value of his totaled car.   Extra miles on the car will have no effect in this comparison.
Car is totaled after	US	Duration in months, when car is totaled after the start of leasing period or car purchase.
With Lease Option
First Payment	CO	First payment made towards lease. Same value as in the Leasing worksheet.
Monthly Payment	CO	Copied from the Monthly Payment field of the Leasing worksheet.
Total Expenses	CA	= First Payment + Monthly Payment * Duration car is totaled after
With Buy Option
Down Payment	CO	Copied from the Down Payment field of the Buying worksheet.
Monthly Payment	CO	Copied from the Monthly Payment field of the Buying worksheet.
Total Money Paid before accident	CA	= Down Payment + Monthly Payment * Duration car is totaled after
Money Paid towards principal	CA	Money paid towards principal is calculated by CUMPRINC function.
Total depreciation of car	CA	Depreciation of the car in the duration car is totaled after. This is calculated by using DDB function.
Present Market Value of Car	CA	This value is calculated by subtracting total depreciation of the car from its selling price. For simplicity reason I am assuming that consumer will get this much money from his/her insurance company for the totaled car (usually that is not true).
Amount Left in Loan	CA	Is calculated by subtracting the money paid toward principal value from the loan amount.
Total Expenses	CA	= Total money paid before accident – (Present market value of car – Amount left in loan)
Conclusion:		If Total Expenses in leasing the car is more than Total Expenses in buying the car then buying is a better option otherwise leasing is a better option.

¹ Type: US – User Supplied, CA – Calculated, CO – Copied from other sheet

Play with the model by changing input parameters (user supplied values) and see which option is better for you.

 

 

Based on a set of questions, the utility model compares the utility benefits of car leasing and car buying options and suggests the better option for the given circumstances (parameters).

The model uses Cobb-Douglas function to calculate the utility values of lease and buy options.

The model has four worksheets - Instructions, Questionnaire, Processing, and Answer. The Processing worksheet is a hidden worksheet and is not accessible by the user.

The model provides the list of values (LOV) for every question hence user has very limited choices for the answers. The model is not tested for the extreme values. It is expected that the users will provide appropriate and meaningful values.

The following questions have to be answered by the user of this model:

Question No.	Question
1	Do you prefer to drive a vehicle for about 2-4 years and then trade it in?
1.1	Rate your desire to drive a new vehicle on a scale of 1 to 10 (NV)
2	Do you average about 12,000 - 15,000 miles on your vehicle annually?
2.1	How many miles you average annually (MI)
3	Do you keep your vehicle in great condition and maintained?
4	Do you like the idea of driving a more expensive vehicle for a little additional monthly cost?
4.1	How much monthly cost you can associate with this idea? (MC)
5	On a scale of 1 to 10, how comfortable you are with the idea that you will own nothing (the car) after the leasing period (ON)
6	Does the idea of tying up money on a depreciating asset bug you?
6.1	Give a rating on the scale of 1 to 10 (DA)
7	Do you like the idea of only paying for what you use?
8	Are you concerned with high down payments, sales tax and high monthly payments?
9	Is the vehicle used for business?
10	On a scale of 1 to 10 how confident you are with the quality/performance of the car? (QU)

 

For some of the questions where user has to put a value from 1 to 10, 1 means low and 10 means high.

The model uses the following form of Cobb-Douglas function to calculate the utility value:

Utility = NV^aMI^bMC^cON^dDA^eQU^fYN^g

 

Question No.	Possible Answers	Input Variable	Parameter Name	Parameter Values (for Lease)	Parameter Values (for Buy)
1	Yes/No
1.1	1 to 10	NV	a	0.3	0.3
2	Yes/No
2.1	10000 to 22000	MI	b	0.05	0.1
3	Yes/No
4	Yes/No
4.1	50 to 400	MC	c	0.3	0.2
5	1 to 10	ON	d	0.1	0.15
6	Yes/No	DA	e	0.05	0.05
6.1	1 to 10
7	Yes/No
8	Yes/No
9	Yes/No
10	1 to 10	QU	f	0.2	0.2
11*	1 to 10	YN	g	0.2	0.2

 

*How many questions have been answered with the value of YES

 

Parameter Values for lease and buy options are my best educated guess based on my research on leasing and buying options done through browsing many related web sites.

For Input variables NV, MI, MC, ON, DA, QU, and YN, values are adjusted based on the user input. These variables can’t have a value of 0 in any case. A value of 0 for any of these input variables will produce a utility value of 0. For the questions where user has to specify a value on a scale of 1 to 10, a higher value usually produces a higher utility value for lease option while a lower value contributes more towards buying option. Most of these adjustments are my educated guess based on my research on leasing and buying options.

 

A value of YES to YES/No type question gives higher utility value for lease while a value of NO gives a higher utility value for buy option.

 

After answering the questions user can go to the Answer worksheet to see whether buying is a better option for him or leasing is a better option for him.

 

 

 

Deciding whether to buy or lease depends on a number of issues, some financial, some purely qualitative.  Some of the questions you should ask yourself before deciding are:

 

• How many miles do I drive per year?
• How long do I want to drive this make/model car?
• What kind of monthly payment budget do I have?
• What deductible business-use percentage will I qualify for?
• How much do I enjoy the feel of a new car?
• How good am I at reading contracts?

 

Some tips for leasing a car:

 

• Shop around; leases are very different, and very negotiable.
• If the car you are interested in is being offered at super low financing, or with high rebates, odds are it will be cheaper to buy than lease over the long run.
• Don't assume the leasing terms for the car you want are set in stone.  Items such as excess mileage, excess wear, early termination clause, advance preparation fees, and Gap insurance can be negotiated to some extent.
• Seriously review the "early termination" penalties.  These are extra charges you may have to pay if you turn in the car early before the lease expires.  Many companies will charge you these penalties (which can be very steep) even if it is not your fault-such as a stolen car, or a car that gets totaled.
• Watch for unusual restrictions in the contract such as where you can and cannot drive the car.  Some leases don't allow you to drive the vehicle out of the country; some don't allow you to drive it out of the state.
• Consider buying Gap insurance especially for the early years.   
• Definitely review the excess mileage clause.

 

 

 

As you can see whether buying or leasing a car is best for you depends on a number of issues - financial facts, lease terms, loan APR and guesstimates.

 

I hope that this paper has provided enough information to explain the leasing terms/definitions, and the leasing process. According to J.D. Powers and Associates, in future more than 80% of the population will lease the cars. I can’t fully support that argument but by putting some real numbers for car buying and leasing options, I surprisingly found that car leasing is also winning for a good percentage of times.

 

I am hopeful that my financial model and utility model will help its users in making their decisions of buying or leasing a car.

 

In my own case I don’t regret that I bought Honda Accord. Because of very attractive APR from Honda Corporation I found that buying was the better option for me than leasing the car. 

 

 

www.kbb.com

www.leasecompare.com

www.carbuyingtips.com

www.euromtradingcompany.com

www.fivestarford.com

www.callac.com

www.smcu.org

www.erhpc.com