Friday, April 18, 2008

How to Buy a Car

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.


  1. My current car was purchased in just the way you described. I was in the middle of selling one house and buying another which gave me the 30K to pay cash for a 1999 Suzuki Grand Vitara. I still have this car and with its low mileage (13000km) I expect it to last a few more years still, providing me with a decent investment.

    However, after talking with a financial adviser (on many topics) he actually convinced me that a much better investment would have been to leave a new vehicle every 2-3-4 years and with the cost savings (not putting down 30K in one lump) and paying a smaller monthly amount I could have invested the difference and come out ahead.

    The golden rule of invest in things that appreciate (the market) and rent the things that depreciate (like cars) appears to make sense.

    This is contingent on various things I understand, such as not putting down a large cash amount on the lease, and I believe not driving above certain mileage each year etc. I have not leased yet so I'm not sure of all the nuances.

    By buying a car you've invested your after tax dollars in something that will only go to $0, that is certain. By leasing you free up your cash to invest and make money.

  2. Anonymous:

    Let me start by saying that this strategy might work out for you if your investments do well. However, I don't agree with your investment advisor's advice.

    I don't believe that you are truly renting your car (assuming that you have typical lease terms). If anything goes wrong with the car that isn't covered under warranty and that makes the car worth less than expected, then you will have to make up the difference. This means that you essentially own the car because you are accepting the same gains or losses as if you owned the car.

    This strategy is a form of leverage because you are essentially borrowing to invest. At the same time, you are paying for the high depreciation period on your cars by buying a new one frequently. If you are like most people who don't analyze the lease terms carefully, you are likely paying more for each car than you realize; possibly more than the list price. Many dealerships push leases hard partly because the deal is better financially for them than a cash sale at list price.

    Most finanacial advisors would not care much about all these considerations. The analysis would go: if you lease, then you will generate more commissions with the extra money that you invest with the advisor.

    If you have taken all this into account and have figured out that leasing works nest for you, then great. But, I think that leasing is the wrong approach for most people.

  3. Thanks for the reply and food for thought. As you say, I don't know what the typical terms are for a lease as I have not done one yet. But, when the time comes I will look carefully at what the commitment is to the value upon return.

    As I understand it even if you were to have an accident the car will be repaired as your mandatory insurance will cover this. What else could go wrong with a car that is not covered by the warranty? Is not the point of a lease the duration you have it (say 3 years) is exactly the length of the full warranty, so you have a fixed cost each month and should not "need" to spend anything more, other then perhaps winter tires or a cup holder. So you avoid "investing" your money into the car.

    Also, times change. Would not the owner of a gas guzzling SUV not love to have a lease about to end so he can get a new lease on a smart car?

    Another assumption I have (without really looking into prices yet) is that the lease is $hundreds less each month then paying the loan to own? So this extra cash is invested and grows more then the money you potentially save after the loan is paid for and the car does not need major repairs or upkeep (say 4 years).

  4. Anonymous:

    Before signing a lease, look carefully at the clauses related to residual value. There may be penalty clauses for mileage, wear and tear, and other things. Also, who gets to decide whether there has been too much wear and tear? For clauses that leave penalties essentially at the discretion of the dealership, you need to know how they have treated other customers (not easy to find out).

    To figure out how much you are paying for the car, you need to take the present value of your expected payments (with all extra taxes and other add-ons) plus the down payment (and other initial add-ons) plus the present value of the residual value (plus expected penalties). If you do this carefully, you may be surprised to find that the total exceeds what you would have paid in a cash deal by a wide margin.

    The logic that warranties cover anything unexpected and so you should not have to pay anything beyond the agreed upon payments seems sensible, but too many people I know have told me that something happened that cost them extra money when it came time to trade-in.

    It's true that lease payments are lower than loan payments. But, at the end of the loan, you own the car. At the end of a lease, you lose the car plus any penalties. To come out ahead, your investments have to beat the interest rate built into the lease. Even worse for those who can't write off lease payments on their taxes, you have to beat this interest rate after paying taxes on your investments.

    When it comes time for you to take the plunge and buy a vehicle, I'll be interested to hear how your analysis works out.

  5. I'm with you 100%. Here's proof:

  6. Patrick:

    Nice post. Some people will find your detailed analysis of a particular case more compelling than my 1000-foot view. Either way, the result is the same: leasing is likely to be a very expensive approach to car ownership.

  7. Patrick: You're right. I oversimplified the situation. I wanted people to understand that leasing a car is not like renting a house. With a house, the renter takes on almost no risk with respect to the value of the house. When leasing a car, the customer is taking on considerable risk. The car company takes on the risk that a class of car as a whole becomes less valuable than expected (in this case due to the spike in gas prices). However, each customer carried the risk that his vehicle in particular was worth less than the average vehicle.

    1. The comment above was in response to Patrick's comment below that I had to edit to remove a broken link:

      Hi Michael. I'm not sure it's fair to say that a customer leasing a car takes on all the risk with respect to residual value; otherwise, why is GM taking huge writedowns for the reduced residual value of their SUVs? (There was a link to a Bloomberg article here.)