Choosing which car you want to drive is not the only difficult decision to make when you are in the market for a new vehicle. Just as confusing can be the choice between leasing or buying. It’s important to look beyond the monthly payment, and understand exactly how each of these financing options work and how they affect you.
Who owns the vehicle?
When you purchase a car, and finance it through a bank loan or a dealership, you retain ownership of the vehicle. A lender may register a charge against the vehicle as collateral against payment of the loan, but the purchaser always retains ownership.
In contrast, when you lease a car, the leasing company owns the car. As a lessee, you have a contract with the leasing company to use the vehicle, and in exchange you make an agreed payment over a specified period of time.
How much are you financing?
When you take out a loan to finance the purchase of a vehicle you are borrowing the full purchase price of the vehicle.
In a lease, you are only paying for the expected depreciation of the vehicle. The depreciation amount is based on the full purchase price of the vehicle minus the agreed upon residual or buyback value.
It is because you are only paying the depreciation value in a lease rather than the full purchase price of the car that monthly lease payments are usually lower, and for a shorter period of time, than the monthly loan payments when financing the purchase of a car.
How is interest calculated?
On a car loan you pay interest on the full amount of the financed purchase price, including taxes. Your monthly payment is determined from an amortization schedule based on the amount borrowed, the term of the loan and the interest rate. The fixed monthly payment includes a portion for principal repayment and a portion for interest. As you make payments you build equity.
A lease payment is also impacted by financing costs, but instead of an interest charge it’s called a money factor. Your total monthly lease payment will be based on a depreciation fee plus a financing charge based on this money factor. Here’s where things get complicated. You might think that you only have to pay the financing charge on the depreciation value however the money factor is actually applied to the full value of the car. This is because the leasing company is using their money to buy the car and they want to earn a return on that full investment.
Which is cheaper?
It’s true that if you lease you can usually have much lower monthly payments. That’s because rather than repaying the full purchase price you are only financing the depreciation amount. Monthly lease payments however do not build any equity because you do not own the vehicle, the leasing company does. Once you are done making your payments, you have nothing to use as a trade-in on your next vehicle.
To compare the true cost of buy or lease over a similar term, the best approach is to compare exactly what you will be paying in total assuming you buy out the car at the end of the lease. This puts you in the same position of owning the vehicle once your payments are finished.
Total lease costs = Monthly Lease Payment x Term of Lease + Buyout
Total loan cost = Monthly Loan Payment x Term of Loan (using the same term)
Over the long term, a lease is generally more expensive than buying a car outright and keeping that car after the loan is paid off.
Can you sell the car?
If you purchase and finance a car, you can sell the car at any time, but you must arrange to pay off the loan in full before you do, including any potential pre-payment charges. Once you reach the end of your loan payments, the security is removed, and you have the right to sell your car with no further obligations to the lender.
Because you don’t own a leased vehicle you cannot sell it. Even at the end of the lease, you do not own the vehicle. Instead you have an option, if you want, to buy the car for the original agreed buyout amount contracted in the lease agreement. You can also hand back the car at the end of the lease.
Early termination of a car lease usually results in high cancellation costs.
Who is responsible for insurance, wear and tear?
Whether you lease or buy a vehicle, you will be required to maintain appropriate insurance. Your leasing company may have minimum standards in terms of collision and theft coverage.
Lease agreements also limit the amount of kilometres you can drive, and if you go over these amounts the charges can be severe. Similarly your lease payment will be based on an estimated residual value assuming the car is returned in good condition. Excessive wear and tear may result in an additional charge when you return the vehicle.
What happens if you default?
If you default on the payments under a secured car loan, the lender has the right to take action to seize the car. They will arrange to sell the vehicle and you will be liable to pay any difference between the selling price (less selling costs and legal fees) and the amount you still owe on the loan.
If you default on a car lease agreement, you must return the vehicle or the leasing company will take action to have the car repossessed. The leasing company will then pursue you for the balance owing on the lease.
Both a default on a loan payment and a default on a car lease will have a negative impact on your credit report.
Is there a difference in the event of bankruptcy?
If your vehicle is fully financed, there is no real difference between a car loan and a lease in the event you file bankruptcy. In both cases if you are able to keep up with your monthly payment you can usually keep your vehicle.
Even if you have repaid most of your loan, there are provincial exemption limits which allow you to keep a car up to a certain dollar value.
Pros and Cons of Leasing
In summary, it’s important that you look at the pros and cons of leasing versus buying a vehicle as well as run some numbers using a lease or buy calculator like this one from the Office of Consumer Affairs.
Benefits of Leasing
- no or smaller down payment
- lower monthly payment
- potentially lower maintenance if you are leasing a car under warranty
Disadvantages of Leasing
- there are up front costs including one month’s lease payment and licensing fees
- additional charges if you go over any mileage limits
- potential costs at the end for excessive wear and tear or damage
- inability to sell or terminate a lease without penalties and fees
- no ownership equity so no trade-in value on your next car
- potentially higher long term financing costs