The concept of borrowing money to buy or lease a new car is a puzzle all its own. Borrowing enables us to purchase more car than we can afford, but often less car than we dream of. However, borrowing isn’t all bad when carefully considered and executed. Financing in general, especially a vehicle, is an excellent exercise in money management. Done properly, the process of obtaining a loan or lease can teach vital budgeting skills that will support a good credit rating and healthy finances for a lifetime. Improperly executed, a lease or loan for personal transportation can set off a domino effect that can lead to bankruptcy.
Hopefully, this article and “What Can I Afford to Spend on a New Car” will help you avoid difficulties. The idea is to know your financial limits ahead of time. Read these articles, talk to an accountant or CPA, or work it out yourself. But make sure to know how much you can comfortably afford. If you don’t have credit yet and want to buy a new car soon, consider obtaining a small bank loan or department store credit card. Use it and pay it off. That way, you can establish a credit record in your own name before going for a car loan. You’ll probably be able to get a better interest rate if you do.
Ultimately, we control how much we spend and how we want to finance our new vehicle. The most important, and often overlooked, issue of financing is the “lump sum” cost of “renting” money. The lump sum is the amount of money (not the percentage, money factor, or payment per month or year), the one big number, that represents what you will pay a lending institution for the privilege of using their money to get a new car.
By Federal Law, loans must show, in print, the total cost in dollars that you will pay to borrow the money for the car. That is not the case with a lease. So unless you are extra vigilant, you won’t know how much a lease is actually costing you. Let’s say, for example, you borrow $18,000 for a new car. The total cost to rent the money will be between $2,000 and $4,000. The money paid is spread out over the life of the loan or lease and may not be clearly stated in the paperwork. Regardless, the “rent” can increase the price of your new car by as much as 30%!
Most People Get Loans For New Cars
A loan is a safer bet than a lease for most people because once all the payments are made, you actually own something. If at any time you want to sell your vehicle, you will usually be able make some of the money back. This money can be used as a down payment on the next vehicle, or for anything else.
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 car you’ll own, than to lease a car you won’t. To compare loans and leases, do the math on a six year car loan versus a three-year lease. The cost of a six-year car loan, when done at the prevailing market rate, is usually lower than the cost of a three-year lease, even though the monthly payments on the lease are lower.
Negotiate For the Car and Financing Separately
Loan and lease negotiations should be handled separately from those for the car. Determine whether you will lease or buy and find financing before negotiating for the vehicle. For advide on getting the best price for the vehicle, read “Dealing with Dealers: Negotiating a New Car Purchase.”
Most people shop for a new car in the conventional way — finding the car before the financing. We recommend a different approach. Get a good idea of which car you want and estimates of its cost online, find your financing and, lastly, negotiate for the final price of the car. When you have financing in hand, you hold all the cards. When shopping and negotiating for your new car, don’t tell the salesperson how you will pay for the car. This can interfere with getting the very best price. Once you have negotiated the best price for the car, take that number to the financial institution giving you the loan or lease (or to the selling dealership, if that’s where you plan to obtain your financing). Have them develop your loan or lease contract based on the negotiated price.
Shopping for a Loan
After you have a good idea which car you want and the appropriate price range for it, start your loan shopping by speaking to an officer at your credit union or bank. Almost all of this work can be done by telephone, fax, or the Internet. With your permission, they’ll even check your credit. They can fax or send you all the forms and contracts so you can read them carefully at home. Even though reading the fine print takes a while, it is a critical task to do and can be very interesting. The loan officer should be happy to explain anything on the application or contract. Normally, it takes only a few hours to a couple of days for a financial institution to approve a loan.
Obtain answers to the following questions:
- What is the lowest APR (Annual Percentage Rate) available?
- What is the longest term available to borrow the money?
- What is the smallest down payment I can make?
- What are the combinations of loan features?
- What is the total cost, in dollars, of the loan (above the amount I am financing — called principal) over the duration the contract?
Loan officers can be your best form of free financing advice. They’ll give you a bank’s eye view of how to size up your financial stability. If you plan your new car purchase a year or two ahead, they can give you useful recommendations for things that can be done to maximize your buying power.
Calling the Finance and Insurance Department (F & I) of a dealership can also be informative. But be careful. They may try to sell you a lease and insurance. Leases are very profitable to a dealership. And their insurance prices are usually much higher than going directly to an outside agent.
If you decide to lease instead of buy — shop for the lease separately and make sure to get information on what the manufacturer of the car you want is currently offering. It could be a good deal. More on that later.
The True Cost of Financing — Loan Tools and Questions
Under the Truth-In-Lending Laws, lenders must measure all loans using the calculation for APR. APR is the interest rate charged each year on the unpaid balance of a loan. Lenders are required to show on the contract, in clearly readable type, the exact cost in dollars of renting the money. However, this is not the case when you finance with a lease.
A loan consists of a number of different components including the loan rate, duration and down payment. The loan rate is the APR depicted as a percentage. The term is the timespan of the loan, and is the number of monthly payments to be made. The down payment, which usually ranges anywhere from 0% to 25% of the car’s price, is the money you offer, or that may be required, to reduce the amount of the loan.
Sometimes, the only way for someone with little credit, no credit or bad credit is to pay a higher interest rate. There are companies that loan to high-risk candidates, but they may charge as much, or more, than 21%. This situation really should be avoided — walk or take the bus for awhile — because so much money will be spent on interest that such a loan can put people in financial jeopardy. It is best to try to better your credit and save for a larger down payment than to buy into this mode of borrowing.
If you have a loan and come into money from an inheritance, raise, bonus or lotto win, loans can be prepaid (paid off early) at any time. This enables you to keep all the money you would have paid on interest for the remainder of the loan in your own pocket.
Contracts, Getting the Money and Making Payments
Most consumer products, with the exception of cars in most states, are governed by laws allowing you to renege on a deal within 72 hours (3 days) of signing the contract, if you decide you don’t want it. This is called “buyer’s remorse.” No matter what your brother-in-law tells you, there is probably no law in your state covering buyer’s remorse for a car. To find out if there is a Buyer’s Remorse Law in your state, call your local Department of Motor Vehicles or Better Business Bureau.
Expect to sign the contract at the bank or credit union branch office. Fortunately you don’t have to go in without having read the contract in advance, as banks and credit unions are quite easy going about sending or faxing both sides of a filled in contract for your perusal. If you are unsure about any aspect of the contract, talk to the loan officer, then speak to an accountant or CPA if necessary.
When the time comes, the bank or credit union transfers the loan money to your personal checking account and you give the dealer a check. Some banks wire transfer directly to the dealers bank. This is common if you are buying an exotic car from a great distance. Commonly, they issue a cashier’s check to both you and the dealer and you sign it over.
The first loan payment is normally due 30 days after signing the contract. However, it is common to delay the first payment for 60, 90 or 120 days if you need to. But, whatever you do, make your car payments on time to avoid late charges, bad credit reports and repossession.
Remember this important detail: the lending institution holds the title until the loan is paid off.
Lots of people become angry about having borrowed too much money and having their life-styles controlled by loan payments. Loan anger usually comes when someone borrows more than they can afford to pay back. Sometimes the problems are beyond our control. Perhaps a layoff occurs or work hours are reduced. Whatever the situation, talk to the lending institution and quickly ask for assistance from your local branch of Consumer Credit Counselors. They may be able to help you keep your car until you find more work and can resume your normal payment schedule.
10 years of Bliss
Fortunately, unlike a lease where you do not own the car at the completion of the contract, you do own the car at the end of the loan contract. Receiving the title to your car is similar to the day you received your diploma. There is a tremendous sense of accomplishment — and relief. It took a lot of discipline to achieve a purchase of this magnitude. Be proud of it!
Once the car is paid for, you may or may not choose to keep it. Good maintenance throughout the life of the car is critical to receiving a good price for it when the time comes to sell. A well-maintained car will be worth thousands of dollars more than a poorly maintained one — even a decade later. It will sell more quickly and easily for top dollar. Another advantage of superior care is increased reliability and safety from the product you’ve picked, nurtured and respected. For suggestions on car upkeep, visit the maintenance section of New Car Buying Guide.
Not too long ago, leases were complex and mysterious. Recently new laws have been passed forcing better lease disclosure. And there are more to come. Be aware of the leasing laws in your state, and, if you choose to lease, be sure your contract adheres to all of them.
Leasing is a legal agreement between two parties that spells out a long-term rental relationship with specific conditions related to the use of property. Normally, this agreement is between a finance company and you. Most leases are available for terms of two to four years. When leasing from a finance company, the property is owned by the finance company; however, you have assumed the responsibility for its condition, maintenance and care in the same manner as if you owned the car.
Car dealerships want to lease cars. They are profitable deals. But, to paraphrase — lessee beware! Leasing is a complicated transaction for which the borrower must be prepared. Leases have rules that are not found in sales contracts. More than likely, there will be restrictions on what can be done with a leased car while it is in your possession.
Signing a lease gives you all the responsibilities of ownership, yet not many of the advantages. The lessee is responsible for all the maintenance, repairs and insurance. However, the car more than likely will be under warranty for the entire term of the lease. Leases limit the number of miles you can drive. Most allow 15,000 miles a year, with a penalty for extra mileage. Get a calculator and add up the miles in your commute, road trips, vacations and errands for a year. If this number is close to the total miles you plan to drive, consider a lease. It is possible to buy extra miles upfront at a reasonable price if you plan in advance. You can request extra miles to be written into the lease during the negotiating process. Address this issue up front and don’t be caught unaware.
People choose leases over loans for different purposes. They may need or want to drive a new car all the time; prefer to drive a car they could not otherwise afford (generally an expensive one); want a lower monthly payment; or can benefit from the tax breaks leases offer. An advantage of leasing is that sales tax is only paid on the amount of each monthly payment. When you buy a car, the sales tax is paid all at once and rolled into the loan.
A friend relayed a story about a conversation between her brother and sister-in-law. They were arguing about the value of loans versus leases. He said leases were about “throwing away good money and you don’t get to own anything.” She argued that she just liked “having a new car every two years.” That she had her “own business and could use the deductions” to her advantage, and he just “had a regular job.” The argument was resolved with input from their accountant who said, “you’re both right! But the wife gets to have her new car every two years, because it helps the tax situation significantly.”
A clear sign that leasing can be beneficial or advantageous is either ownership of a business or the need for direct business use of a vehicle. Ask an accountant or CPA if it would be beneficial to lease a vehicle. Have them compare loan and lease rates and determine if the potential write-off of a lease benefits your business. If the car is for personal use (errands, vacations and getting to and from work), leasing will have less advantage.
The most significant difference between leases and loans is that with a loan you actually own the car in the end. The car, in the case of a loan, is a near-liquid asset — it is easily turned into cash. Successfully completing a loan affects your credit rating in a positive manner, while a lease is neutral.
The type of vehicle makes a real difference in the lease. It is often nearly impossible to lease sports cars because they are likely to be abused and may not be worth enough at the end of the lease if they are damaged or have too many miles on them. Luxury sedans are easy to lease (like Mercedes, BMWs, Jaguars, Lexus and Acuras) as are trucks and minivans.
Devaluation (aka Depreciation)
In leasing, it is common to find two different car models that sell for the same price, yet have different monthly lease payments. Even the lease terms may be exactly the same. This occurs because cars devalue at different rates. Devaluation is the rate at which a car loses value and they lose value for a variety of reasons.
The way devaluation affects your lease has to do with how much the car is expected to be worth (to sell or release) at the end of the contract. Cars that devalue slowly generally are cars that are perceived as high quality and therefore can be sold for more money later. They will have lower lease payments. All of this is affected by not only the make and model, but the options in the car. If you choose a car that devaluates at a rate $100 per month it will have a lower monthly payment than one devaluing at $200 per month. It doesn’t matter what price range your car falls in, variation in devaluation rates occur at all price levels. Picking a slowly devaluating car is critical to obtaining both a good rate and a superior lease.
You can find rates of devaluation for all makes and models in “The Automotive Lease Guide” available at your lending institution. But the average rate of depreciation in the first year will be between 15 and 20%. Each year there after it will be about 10%. After 5 years, the average vehicle will be worth 67% of its original value. Luxury and sports cars devalue at the slowest rates.
Whatever you do, demand full disclosure of all the terms when you enter into a lease agreement. Any dealer unwilling to give them to you in writing does not deserve your business. Do not continue your negotiations. Know all the facts or walk.
Obtain answers to the following lease-related questions:
- What is the cash price of the car?
- What is the capitalized cost of the lease?
- What is the residual value of the car?
- If I want to purchase the car at the end of the lease, what will I pay for it?
- What is the term of the lease?
- What money will I have to pay to start the lease? What is that money for? How much cap reduction is needed, if any?
- How much is the monthly payment and what is it made up of?
- On what rate is the lease payment based? What APR does that equate to?
- How many miles may I drive the car each year?
- What is the per mile charge for overage?
- What will I be charged to terminate the lease early? What is the price if I buy the car at the time of termination?
- How much money am I responsible for if the car is stolen and not recovered or totalled in an accident?
- Is it worthwhile for me to purchase Gap Insurance?
- What constitutes “excess wear and tear?” What will I be responsible for?
- What maintenance and repairs are covered by the warrantee and which are not?
- Does the lessor provide any special services, such as loaners, when my car is being repaired? What costs are involved?
Reading A Lease
Some aspects of lease agreements are unacceptable. For example, some contracts forbid travel out of the area you live in for long periods of time, making a vacation or family emergency an inadvertent violation of the agreement. Many require written permission to leave the country. As much of the U.S. borders Canada and Mexico, a simple day trip can violate your lease. The penalties are listed on the agreement. Be sure to know what the prohibitions are before you sign the lease. Once you sign the lease, you are obligated to live with them. Remember also that every aspect of the lease is open for negotiation.
Some leases require more insurance than normally required for an owned vehicle. Given the price of insurance, it’s a good idea to get an estimate before signing the lease.
You’ll likely be responsible for all wear and tear to the car. Nicks, dings, and scratches that might be ignored if the car were owned, have to be fixed before the end of the lease. The contract will control the condition the car must be in when it is returned — four matching tires may be required, a slight cigarette burn covered by a sun visor may require the complete replacement of the headliner costing hundreds of dollars, a chipped windshield repaired with a patch may be detected forcing you to replace it. Things that might be overlooked during ownership of a car may be required under a lease. And customizing the car to your own personal specifications generally isn’t allowed. Fortunately, not all leasing companies are so rigid and many of these requirements are falling by the wayside in order to motivate more leasing.
Lease contracts should be easy to read. Everything should be spelled out in plain, understandable English. An excellent research exercise is to stop by a dealership and a private leasing company to obtain a blank copy of the lease for the car you want. If you’re unsure of anything you read, ask someone who is comfortable with legal language, or an attorney, to help you evaluate the contract. Most dealers can finance you through a number of different lease companies. Each one will have their own contract and each needs to be read separately. Make sure there is plenty of time to read the contracts and don’t let the salespeople wait till the last minute to show them to you. Check for hidden charges that have not been discussed. For example, no one may have mentioned the “inception fee”. That’s a charge for all the paperwork that has to be done with the financial institution. It is usually around $150.
Look for information about Gap insurance. It is important. Gap insurance covers situations such as the theft or totaling of the car where you end up owing more on the lease than the car’s actual 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.
Once you sign the paperwork, you are done with the process. All you have to do is pick up the car. The financial institution gives the money directly to the dealership.
Lease Payment Components
The most significant components of lease payment calculations are:
- Capitalized Cost: This is everything with a dollar value covered by the lease. Capitalized Cost = Vehicle Price + Fees + Taxes.
- Capitalized Cost Reduction: Also called Cap Reduction, is like a down payment used to reduce the amount to be financed.
- Lease Rate or Money Factor: This factor is used to calculate the interest portion of the monthly payment. Money factors look like .0033. Multiply that number by 2400 to get the true APR. In this case, it is 8%.
- Residual Value: The anticipated market value of the vehicle (what it can be sold for when it is returned) at the end of the lease as determined
- by the leasing company. It is based, in part, on how the car devaluates.
- Term: The length of the lease in months.
Payments are based not on the capitalized cost, but rather the estimated amount of depreciation. You’re paying only for the “used up” portion of the car’s original value, not the original value. That’s why it is so important to negotiate for the lowest possible price on the car before agreeing to lease. The monthly payment is based on the difference between the negotiated price and the estimated residual value, plus interest. With a three year lease, the residual value will be about half of the car’s original value.
LEASE OR LOAN TABLE – (Monthly payment per $1,000 of loan or lease)
|% / Year||2||3||4||5|
For example, if the capitalized cost, including tax and fees, less the cap reduction and the residual is $10,000 and the money factor (converted to APR) is 8% on a 3-year lease, you’ll pay somewhere in the vicinity of $313.40 a month.
Open-end lease payments are based on an “estimated” residual value of the car. If the “actual” value is less at the end of the lease, you must pay the difference. Closed-end lease residual values are predetermined before the lease is signed. At the end of the lease period, you have the option to purchase the car for this price, plus a small fee, or the vehicle is turned back to the dealer and they are responsible for it. You walk away. A closed-end lease is the most popular form of lease, for obvious reasons. But it points to the importance of negotiating a good price for the car from the start. Negotiate for the price of the car in the same way you would if you were buying it. When it comes to leasing, every thing’s negotiable. Even issues that arise at the end of the lease are negotiable, and it is even possible to purchase the car for less than the residual price at the end of the lease. If you are a good negotiator.
Despite all the potential issues that exist with leasing, not all leases are bad. Many are a good value, especially if you own a business or drive as part of your work. There are good leases from many of the automakers. Car companies like Jaguar, Mitsubishi and Infiniti have done a wonderful job of growing their customer base with company-supported leasing. Generally, dealerships no longer directly float loans and leases as they had in the past. Banks, automakers and independent finance companies now support automobile financing for the dealerships. Most financial institutions will convert your lease to a loan after the lease term, if you want to keep the car. They will take the residual and convert it to a conventional loan by refinancing the amount you still owe. It minimizes the up-front costs, but you’re paying a lot more for the financing in the end.
In analyzing financial transactions, there are many more people who become angry with their leases than those angry with their loans. Because the financial institution has more money at stake with a lease than a loan, they are quicker to repossess if the payments get behind schedule. Then, at the end of the lease, when a buyer would be free of the deal, the contract raises its ugly head and the lessee pays for extra miles, nicks and scratches. If after six months, you realize you have the wrong car — you just don’t like it — if you have a bank loan, the car is usually worth more than what is owed at any given time. So, the car can be sold and the loan paid off. You may even turn a little profit. With a lease you are obligated to keep the vehicle because what is owed is generally more than the car is worth. On top of that, if you do decide to get rid of it, there may be early termination penalties. It’s difficult to get out of a lease without losing money and, understandably, that makes people angry.
Terms you will likely find on a lease contract
These terms are found on lease contracts. You won’t find them all on any one contract, and on each they’re interpreted differently. Each lease is a piece of contractual artwork. The most colorful and easy to read is Ford’s new “Red Carpet Lease.” Mercedes new “First Class Lease” is written in plain English and pretty easy to understand as well.
- Applicable law
- Charges for fines paid
- Credit life and disability insurance
- Damage, destruction, or loss of vehicle
- Depreciation amounts
- Disposition charge
- Early termination
- Estimated residual value
- Estimated wholesale residual value
- Excess mileage charge
- Excess wear and tear
- Failure to return the vehicle
- Guaranteed auto protection (GAP)
- Late charges/traffic tickets
- Late charges and collection charges
- Loss, destruction, confiscation or theft of vehicle
- Important miscellaneous provisions
- Maintenance, expenses, fees, licenses, inspections
- Mechanical breakdowns
- Mileage allowance
- Monthly rent payment allocation
- Optional mechanical breakdown protection
- Option to purchase
- Payment of rent
- Prohibited use of vehicle
- Purchase option price
- Realized value
- Removal of vehicle from state
- Return of vehicle
- Risk of loss; gap waiver
- Safe drivers
- Security deposit
- Security interest
- Service/Extended warranty options
- Special loss protection notice
- Taking care of the car
- Termination liability
- Total depreciation
- Voluntary early termination
Leasing requires a good credit record. It also means developing a high level of awareness about leasing fees, charges and contracts. If you have trouble reading small print, take a magnifying glass with you to the contract signing., because missing a critical clause can make it easy to loose $2,000 – $3,000 on a bad lease. Take a good look at any paperwork you are given and make sure all your questions are answered before you sign. Try to read the contract ahead of time, so nothing unexpected comes up at signing.
Advertised leases are meant to look genuinely cheap and affordable. $199 per month, with no money down, leaps from the page and television screen. It is inviting and seems so reasonable. Our head says, “Hey, I can afford that, where do I sign?” Sometimes the lease is just as it is advertised, a great deal. But more often than not, there are hidden fees and unexplained deposits. Buyer beware! It might be wise to sit on your hands for a couple of days and see if that lease still sounds attractive. Again, negotiate the lease separately from the car. If the lease and the car are offered as one big deal, examine the components of the package separately. What is the price of the car on which the lease is based? Was it the lease that attracted you, or the car? Keep your eye on the car you want, not the financing. Examine all the financing options to find an agreement with which you can comfortably live.