SPECIAL REPORT: Car Leasing Is Much More Expensive Than You Think

If you're like a lot of drivers these days, you're leasing a new car every few years. And it seems to make perfect sense. You're always driving a shiny new ride equipped with the latest technology, and the payments are about half what they'd be with a three-year loan. 

Plus, your vehicle always is covered by the manufacturer's bumper-to-bumper warranty.

So, what's not to like? Nothing, if you don't mind paying thousands of dollars more than if you simply bought the car and held onto it for the long term. 

The reality is that leasing, with its low monthly payments, is a deceptively expensive way of acquiring a vehicle, especially if you lease repeatedly. And the cost will only get higher as interest rates rise. Yet, leasing remains popular. Currently, about a third of new vehicles are leased, often by those who already are financially stressed.

This story explains what's really going on under the hood when it comes to leasing. It includes a lease-versus-buy comparison that likely will shock you.

Understanding leasing

First, a quick leasing overview. Leasing is an alternative way of financing a car. For example, whether you lease a $30,000 car or take out a loan to buy it, you're borrowing $30,000 (assuming no down payment), and you'll be charged interest on that entire amount minus whatever you pay back along the way.

And that's the difference between leasing and buying: The amount you pay back. With a loan, you'll pay back the entire $30,000. But with a lease, you'll pay only the so-called depreciation, the vehicle's loss in value while you're driving it. Over a three-year lease, that might come to around $15,000, half as much as you'd pay with a loan. And that's why those lease payments are so much lower, and it's why many people lease again and again. But unlike with a loan, you won't own the car at the end of a lease. Instead, you'll return the vehicle, now worth the remaining $15,000 (the so-called residual value), unless you decide to buy it. 

If this were all there was to it, the net cost of leasing and buying should be equal. The lease would cost $15,000. The loan would cost $30,000, but you'd end up owning a vehicle worth $15,000 at the end, for a net cost of $15,000.

But there's more to consider, among them those pesky finance charges. Because you're paying back less with a lease, that leaves a greater unpaid balance subject to a finance charge month after month. For example, the monthly balance for a lease on that $30,000 car is $22,500. At a three percent interest rate, the average monthly balance for a loan is about $15,700. As a result, with a lease, you'd be paying interest on an average of nearly $7,000 more every month.

But the biggest financial issue with leasing is that it puts you on track to get a new car every few years. That may sound great, but it's really expensive. That's because cars lose their value the fastest when they're new. In fact, a new car can depreciate 20 percent during just the first year. So, if you keep leasing, you'll end up on a new car merry-go-round, in which you're constantly paying that super costly depreciation. Compared to buying and holding onto the car for the long term, you'd be paying thousands of dollars more, as I'll show you in a moment. Of course, that same problem occurs if you buy a new car every three years, too. But with a lease, you're forced to take action every time the lease ends; and for a lot of people, the temptation to lease yet another new vehicle is too much to resist.

Beyond that, leasing has extra costs you won't have to pay if you buy, such as the so-called acquisition fee, which these days ranges from around $600 to $1,000 every time you lease. More on that later.

Lease vs. buy

So, let's look at a lease versus buy comparison.

First, it's important to understand that for most people considering a three-year lease, the alternative is not a three-year loan, which would have monthly payments about twice as high as the lease. Instead, the alternative is a six-year loan, which would have about the same.

That's why, for our comparison, we'll look at two motorists, one who opts for two back-to-back three-year leases on a $30,000 car and another who takes out a six-year loan for the same vehicle. We'll assume the car has an average three-year depreciation of $15,000, and we'll use a manufacturer-subsidized three percent interest rate for both the lease and the loan. For the down payment, we'll assume the buyer puts down $1,800 to cover six percent sales tax, which, unlike with a lease, must be paid up front. We'll assume the lessee contributes the cost of two $695 acquisition fees.

Now let's compare the three major costs: the principal, interest and state sales tax.

Principal: As I explained earlier, the lessee's monthly payments will be based on paying back $15,000, compared to $30,000 for the purchaser. But remember, the lessee is leasing twice. This means that by the end of the second lease, the lessee will have paid back the same $30,000 as the motorist who bought the car. Now, here comes the big difference: After returning the vehicle after the second lease, the lessee has nothing. In contrast, after paying off the six-year loan, the buyer still will have a car worth around $10,000, if not more, for a net cost of $20,000. And that $10,000 difference will be even greater if the vehicle price has increased by the second lease.

Interest: Because of that higher unpaid monthly balance under the lease, the lessee ends up paying $2,025 more interest than the purchaser over the same six years. And it gets even worse if interest rates have increased when it comes time to lease again, a good bet given that rates have been on the rise. Even if the lease and loan rates were just one percent, the lessee still would pay $675 more. (The interest charges would be less if either motorist made a larger down payment, but that wouldn't affect the $10,000 difference in the principal payments.)

State sales tax: Instead of taxing the entire cost of the car, as with a purchase, most states tax only the monthly lease payments. That results in a huge tax advantage for the lessee. For example, in our comparison, the buyer would pay tax on $30,000, while the lessee is taxed on just $15,000 plus the $1,022 interest. But since the lessee is leasing twice during those six years, he's taxed twice, too, leaving him paying more tax than the motorist who bought the vehicle. In other words, when you lease twice compared to simply buying and holding onto the car, you're effectively giving back the sales tax break you got during the first lease and then some.

Adding things up

When you add to all this the two lease acquisition fees totaling at least $1,190, the net cost for the lessee is nearly $13,000 higher than for the buyer. And the amount would be even higher if the lessee is charged additional fees for causing damage or other so-called excessive wear and tear to the car or for driving more than the allowed number of miles. Some leases limit lessees to just 10,000 miles annually, charging the lessee 10 to 25 cents for every mile over the limit. The purpose is to compensate the leasing company for greater-than-expected depreciation. But the actual loss in value is likely to be far less than the fee. 

For example, Kelley Blue Book reports that the trade-in value for a three-year-old Toyota Camry declines by around five cents for every mile driven over 30,000 miles. Conversely, if you return the leased vehicle having driven less than the allowed number of miles, you will have paid for depreciation you didn't use. 

One thing I haven't factored in is the amount the lessee would save in maintenance and repair costs by always having two relatively new cars, both covered by the manufacturer's bumper-to-bumper warranty, which typically lasts three to four years.  In contrast, the buyer will go two to three years without comprehensive coverage. Still, the purchased vehicle will likely be covered by the manufacturer's more limited power train warranty, which usually lasts six years, but with some carmakers can be as long as a decade.  

But even if the car buyer incurs some repair and maintenance charges the lessee avoids – such as a new battery, brake pads and set of tires, they're unlikely to cost anywhere near the more than $12,000 the purchaser saves, especially if the car is a reliable model that's well-maintained. And when it comes to maintenance, car owners can save a lot by skipping those pricey repair shop maintenance packages.

When leasing might pay off

There may be some instances in which leasing might be the better financial choice. One example is if a carmaker is offering incentives to lease customers without providing an equally valuable package of rebates or low-interest financing to buyers. Another example is if your plan is to buy a vehicle using a long-term loan but to trade it in within the first couple of years or so. In that case, you will have paid back so little of the loan that leasing could be a less or equally expensive alternative. But in either of these cases, figuring out whether a lease or loan is less costly is extremely difficult.

If you always want to drive a new car

You may have read that leasing makes sense if you want a new car every few years. But even then, there's a better way. Instead of leasing, buy the first car using as short a loan as you can afford. Then, once you've paid off all or most of the loan, trade in or sell the vehicle, and roll the amount you get into the down payment on the new car. That will reduce the size of your next loan and leave you with a low lease-like payment without all the lease-related headaches. But even then, you'll end up paying thousands more than if you just kept one vehicle for the long term.

What to do

If money's no object, leasing may be for you. You can get a new car every few years without worrying about trading it in or selling it on your own. 

But that's not the case for most people. For many, leasing is a way of getting a new car they otherwise couldn't afford because their income is too low and they have little or no savings. As a result, many lessees, already financially stressed, end up choosing the most expensive way of acquiring a vehicle, one that leaves them making unending monthly car payments.

If that's you, forget the lease and consider buying a car instead. The best way is to save your money and pay cash. But if you can't do that, choose a vehicle that you can comfortably afford while still covering your other expenses and putting away some savings. The rule of thumb is to choose a car that you can afford with a loan of no more than 48 months and to make sure you can make at least a 20 percent down payment. Depending on your finances, that may mean having to settle for a used vehicle. If you need to lease or take out a long-term loan with little down payment, you're opting for more car than you can afford.