The invention of the car lease was a tremendous boon for the car industry. Few people can understand the financial implications of car leases, and at the same time, leases have lower payments than car loans. Many cars would not have been sold if the car lease didn’t exist.
Even the word “lease” works well here. It gives the illusion that someone else is taking the financial risks of car ownership, and the driver is just leasing it. But, you are taking the risks whether you buy or lease.
The idea behind a car lease is simple enough. With a 3-year car loan, the full car price is spread across 3 years at some interest rate. For a 3-year lease, the difference between the car price and its expected value after 3 years is spread across 3 years of payments at some interest rate. After the 3 years, you have to pay the residual amount (possibly by selling the car back to the car company).
Naturally, a lease gives lower payments than a loan for those 3 years making the lease seem attractive. Car companies have strong incentives to make the payments as low as possible to attract car buyers. The money lost in payments has to be made up in various fees charged at the end of the lease’s term. Essentially, the lease overestimates the car’s residual value and penalty clauses kick in when the car isn’t worth as much as predicted.
Few people can understand the financial implications of lease contracts, and it’s not surprising that car leases are a bad deal for most car owners. A possible exception is for people who can deduct lease payments on their taxes (such as the self-employed), but even then the economics may not work out well.
It may seem that I’m about to argue for car loans over leases, but that’s not where I’m headed. In fact, I think both options are a bad idea for most people. It is usually a bad idea to go into debt for a depreciating asset. Almost all cars are expenses, not investments.
The best approach to buying a car is to save up for it, pay cash, and then start saving immediately for the next car. If people bought cars this way, they would think twice about overpaying for a car that is much more expensive than they need.
It’s safe to say that few people will take this approach to car buying. But for those who do, the financial benefits will be huge.