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My Next Car: Pay Cash, Borrow or Lease?

The finances of buying a car can be tricky.  In addition, there are so many other things to consider. What kind of car do I like?  How often do I want to replace my car?  How many people (and pets) do I need to be able to transport comfortably?  Through what weather conditions do I need to drive? Do I want a new or used car (as discussed here)? In this post, I’ll focus on the finances of purchasing a car once you’ve decided generally what car(s) fit your other needs.  Specifically, I’ll describe the financial considerations of three options for buying your next car: pay cash, borrow or lease. I will also provide a spreadsheet to allow you to compare the finances of specific deals.

The Basics of Leases and Loans

I have a post that provides all the basics you need to understand about loans.

There are plenty of resources available to provide you with information about leases, so I won’t repeat that information here.  Here are a few resources:

  • This article focuses on teenagers, but it covers a lot of important aspects of leasing. Consumer Reports is considered an independent source for information about purchases.
  • Edmunds is a company that values and researches cars, as well as having a platform for selling used cars. Its guide on leasing can be found here.
  • The first several sections of this post by Debt & Cupcakes (@debtandcupcakes) provide details about leasing, along with the pros and cons.
  • Real Car Tips also has a guide for leasing. Here is the link for the leasing guide.

Your credit score is an important driver of the terms you will be offered whether you lease or borrow.  When I looked for examples on line, all of the offers were contingent on your credit score being above 800.  A credit score of 800 is excellent.  I have a post on how you can check and improve your credit score.

The Finances of Owning a Car

Cars are expensive to own.  This post will focus on the cost of buying a car under three different options – cash, borrowing and leasing.  As you evaluate which of the options works for you, you’ll also want to make sure you are able to afford the other costs of ownership of a car.  In addition to the purchase costs discussed below, there are four other categories of expenses:

Fuel

Your car needs gas, diesel or electricity.  As you are selecting a car, you’ll want to consider the type of fuel your car needs, the miles per gallon the car gets and how many miles you are going to drive.

Registration

You will need to register your car every year.  In the states in which I’ve owned cars, registration is a function of the value of the car – the higher the value, the higher the registration fees. I recall that a car worth $20,000 cost about $300 to $400 a year to register, whereas the minimum charge (for older cars) was about $50 a year in Minnesota, but the amounts vary widely across states.  In other states, registration fees are a flat amount regardless of the age or value of your car.

Insurance

In all states you are required to buy car insurance. This post provides information on insurance you are required to purchase and coverages you might want to purchase.  Liability insurance usually doesn’t depend on the value of the car, though can be higher for sportier and faster cars.  The premiums for physical damage coverages (comprehensive and collision which protect you against damage to your car) increase with the value of your car.

Maintenance & Repairs

Cars need regular maintenance – oil changes, replacement brakes and tires, among other things.  Some dealers provide regular maintenance at their location for one or more years if you buy a new car, but that is not always the case.  In addition to regular maintenance, cars break down and need to be repaired.  Repair expenses tend to be higher on older cars.  Even on new cars, repairs can be expensive and unexpected.

You’ll want to keep some money in your designated savings for car repairs, as discussed in this post.  Another option is to buy an extended warranty to cover repairs to your car.  Extended warranties can be quite expensive, but cover the cost of some major repairs if they are needed.  I’ll write about extended warranties in another post in the future. If you choose to purchase an extended warranty, you’ll need to include that cost as part of your expenses related to owning the car, along with a provision for repairs not covered by the warranty.

How to Think About the Finances of Buying a Car

Determine Your Needs

I always find it helpful to define what I want and can afford before I go shopping for anything expensive, cars in particular.  My husband does all of the negotiating on price for our cars because that is a skill I never acquired and I don’t like the process so don’t want to acquire it.  I figure out what I need, what’s available in our price range that meets those needs and make a very detailed list so he can go to different dealers to negotiate the terms.

As part of your needs, you’ll want to think about the length of time you’d like to own your car.  Some people like to drive a new or at least a different car every few years.  I was that way when I was young – I bought a different car every 3 years for a bit.  I’ve always regretted selling the first one – a 1969 Mustang convertible. Live and learn!

Other people drive cars until they die or become unreliable.  Now that I understand the finances of cars better, I have moved to the second category.  The most recent two cars I’ve sold (both Honda Preludes) had 250,000 and 150,000 miles on them respectively.  The only reason I sold the second one is because I moved to a place with hills and snow, as opposed to flat and snow, and a Honda Prelude just wasn’t going to get me home reliably in the winter.

Figure Out What You Can Afford

The second step in the process – figuring out what’s in your price range – can involve several perspectives.

  1. How much cash do you have available to either pay for the entire car or put as an initial payment towards a loan or lease? As you consider that amount, you’ll want to take the total cash you have available and reduce it for the other costs of ownership I’ve listed above.
  2. If you aren’t going to pay cash for the car, how much you can afford to pay every month? Again, don’t forget that you’ll need to pay for registration, insurance, fuel, maintenance and repairs, too.
  3. If you can’t find new cars that fit in your budget, you might need to look at used cars. I have another post planned that will address the finances of buying new versus used.

Gap Insurance

Gap insurance is another expense you may have to pay if you don’t pay cash for your car. In some cases, you’ll want to buy it for your peace of mind.  In other cases, the lender or lessor may require it.

Gap insurance protects you against the difference between the value of the car and your outstanding balance at any point in time during the loan or lease.  Although it may not be clearly stated in your lease agreement, lessors think of your lease payments as including compensation to them for the reduction in the value of the car as you use it (depreciation) and interest on the value of the car (similar to loan interest).  As such, both loans and leases have outstanding balances at all times during their terms.

The chart below compares the outstanding balance on a loan with an estimate of the value of a $23,000 car over the term of an 84-month loan.  For this illustration, I’ve assumed that the borrower paid $1,000 towards the value of the car as a down payment and the loan has a 3% interest rate. I estimated the value of the car by looking at the clean trade-in value of a Ford Fusion from prior model years on the National Automobile Dealers Association (NADA) web site, a common source for lenders to get car values.

For the Ford Fusion, the loan balance is more than the value of the car between 4 and 36 months.  If the car is totaled, your car insurer will reimburse you for the value of the car minus your deductible.  During that time period, you will owe the lender not only your deductible but the difference between the blue line and the orange line.  To protect yourself from having to pay the additional amount, you can buy gap insurance.

You’ll want to investigate the cost and need for gap insurance for the particular make and model you are buying.  Cars depreciate at different rates.  For example, when I looked at the NADA web site for a Subaru Impreza, the value never went below this illustrative loan balance.

The Finances of Cash, Leases and Borrowing

Now that I’ve covered the preliminaries, we can get to the main topic of this post – the details of paying cash, borrowing and leasing.

Cash

When you pay cash for a car, there is only one number on which you need to focus. It is the out-the-door cost of buying the car.  This amount will include some or all of the following:

  • The cost of the car,
  • The additional cost of options you choose,
  • Sales tax (called excise tax in some jurisdications),
  • Processing and documentation fees,
  • Delivery charges, and
  • Title and registration fees.

Not all of these charges are included in every state or by every dealer.  I recently bought a new car in Montana. There is no sales tax in Montana, there wasn’t a delivery charge and you pay the state for title and registration fees directly, so the only things on my invoice were the cost of the car, the cost of the two options I added and a $100 documentation fee.  If you are comparing prices from different sources, you’ll want to make sure that they consistently treat all of these possible costs. For example, you should make sure they either all include or all exclude title and registration fees.   If not, you’ll need to add them to your analysis of the total amount you can pay for the car.

Leasing

The finances of leasing involve many important numbers, even more than borrowing.  All of these numbers should be available to you in the contract and from the dealer or leasing company. 

Up-front Payment

You’ll want to make sure you know the total amount of the up-front payment, including sales taxes, title and registration fees and the base charges from the dealer and finance company. The up-front payment often includes the first month’s lease payment, but not always, so you’ll want to be sure to know whether it is included for each offer you consider.

Monthly Payment

The amount that you’ll pay every month.

Sales Tax Rate

You pay sales tax on your monthly lease payments.You’ll need to know if the sales tax is included in the monthly payment you’ve been quoted and, if not, what sales tax rate applies.

Term

The term is the number of months you are committed to the lease. It is important to note that my spreadsheet assumes the lease term is 36 months and you will honor your commitment to the lease for its entire term.  There can be significant penalties if you choose to return the car before the lease ends.

Allowed Annual Mileage

Every lease contains a maximum number of “free” miles you can drive on average each year.

Estimated Actual Annual Mileage

You can use your actual annual mileage to estimate how much you will have to pay in excess mileage charges to understand the full cost of a least.

Cost Per Extra Mile

If you exceed the total allowed mileage (the allowed annual mileage times the term), you will pay an extra fee when you return the car. To calculate the extra amount, you first take your actual mileage and subtract the total allowed mileage.  You then multiply the excess miles by the cost per extra mile.  As I’ve looked on line at leases, I’ve seen several that charge 15 cents per extra mile.  If, for example, you drive 50,000 in three years on a car with 12,000 miles allowed and a 15 cent per mile charge, you will pay an extra $1,800 when the lease ends.

You may also need to pay a fee if your car experiences more than the normal amount of wear and tear. For example, if you live on a gravel road or a busy street, your car may have many more nicks and dings than someone who lives on a quiet paved cul-de-sac.

Residual Value

If you think you might want to buy the car at the end of the lease, you’ll need to know the residual value.This amount is what you will pay to keep the car.

Monthly Cost of Gap Insurance

If you want or need to buy gap insurance, you’ll want to know by how much it costs each month. You can buy gap insurance from your car insurer and, sometimes, the dealer, though I’ve read that buying it through the dealer tends to be more expensive.

Borrowing

The finances of taking out a loan for a car are a bit less complex than leasing. Here are the important numbers you need to know.

  • Up-front payment – You’ll want to make sure you know the total amount of the up-front payment, including sales taxes, title and registration fees and the base charges from the dealer and finance company. The up-front payment often includes the first month’s lease payment, but not always, so you’ll want to be sure to know whether it is included for each offer you consider.
  • Amount financed – This amount is equal to the total value of the car minus the portion of your up-front payment that goes towards paying for your car.
  • Monthly payment – The amount that you’ll pay every month. There is no sales tax on loan payments.  The sales tax was considered in the total amount of the car used to determine your up-front and monthly payments.
  • Interest rate – The interest rate, along with the amount financed and monthly payment, are used to determine the remaining principal on your loan at point in the future. If you want to sell your car before you have paid off your loan, you’ll want to be sure to know the amount financed and the interest rate so the spreadsheet can calculate the remaining principal.
  • Loan term – The term determines how many monthly payments you will make.
  • Monthly cost of gap insurance – If you need or want to buy gap insurance, you’ll want to know by how much it costs each month.

Illustrative Comparison

Because I just purchased a Subaru Impreza for around $23,000, I use it and two other cars advertised as having similar costs as illustrations.

The Offers

The table below summarizes the values I found on line and/or created for a Subaru Impreza, a Toyota Camry and a Ford Fusion

Although the cash prices are similar, the Lease and Borrow options have fairly different terms. The amount due at signing and monthly payment are much lower for the Toyota Camry lease than for the other two cars. The interest rates on the loans are very different, even though the monthly payments are all essentially identical. The Subaru has a lower interest rate and shorter term than the other two cars.  Because the payments are the same and the interest rate is higher, the amount due at signing must cover more of the cost of the Toyota than for the other two cars.

Not all of these values were clearly identified in the terms I found on-line.  The actual offers could be somewhat to significantly different from the values I’ve shown above.  Nonetheless, the differences in the terms help differentiate the total financial cost of these offers.

Look at Just the Subaru

We will first look at a comparison of the three options for the Subaru Impreza. Before we can do that, you need to determine for how long you want to own the car.  For illustration, I’ve looked at two options – own it for the term of the lease (assumed to be 36 months) or own it until it dies (or at least until you’ve made all of your loan payments).

Sell in Three Years

The first row of the table below shows the total of all of the payments you will make under each of the three options over the course of the first three years.  For the Cash option, it is your out-the-door cost. For the Borrow and Lease options, it is the sum of the amount due at signing, your monthly payments and the monthly cost of gap insurance.  For the Lease option, I added sales tax to the monthly lease payments.

Three Years Cash Borrow Lease
Upfront Cost + Monthly Payments $23,691 $14,133 $15,971
Amount on Sale 12,000 761 -1,350
Net Cost 11,691 13,372 17,321

The second row shows how much you would get or pay at the end of 36 months.  For all three cars, I have assumed you can sell them for $12,000 after three years. For the Cash option, the second row shows the total sales price of the car.  For the Borrow option, it is the difference between the $12,000 sales price and the loan balance.  For the Lease option, the value is negative meaning it is an amount you have to pay instead of receive.  It is the charge for the extra miles put on the car.  If you look at the inputs table, you’ll see that there is a 15 cent per mile charge for every mile over 12,000 a year and I have assumed you will drive 15,000 miles a year.

The third row shows the total net cost, calculated as the first row minus the second row.  For the offers for the Subaru Impreza, the Cash option is cheapest if you plan to sell after 3 years.  If you can’t afford to pay cash up front, the Borrow option is preferred to the Lease option.

Drive Forever

Under the Drive Forever option, the sales price of the car is assumed to be essentially zero, so we can look at just the cash outflows.  The table below summarizes the total cost of the three options.

Drive Forever Total Cost
Cash $23,691
Borrow 25,581
Lease 31,321

The total cost of the Cash option is the same as in the Three Years table.  There are no purchasing costs other than the amount paid at signing under this option.  For the Borrow option, the total cost has increased from the Three Years option because it now includes the monthly payments after three years until the loan is fully re-paid.  For the Lease option, the cost has increased by the residual value of the car, $14,000 in this case.  That is, in addition to the up-front and monthly lease payments, you’ll need to pay the $1,350 for the extra miles and $14,000 to buy the car from the lessor.

Using the longer time frame, the Lease option is even more expensive than the Borrow option.  Because the interest rate is fairly low, the additional interest paid after three years isn’t a lot so the difference between the Borrow and Cash options doesn’t increase by a large amount from what was observed for the Three Years option.

Look at All Three Cars – Three Years

The relative order of the three options varies depending on the terms of the offer. The graph below compares the net costs of ownership of the three cars if you anticipate selling the car in three year.

The values for the Subaru Impreza are the same as the ones in the third row of the Three Years option table above.  As can be seen, leasing isn’t always the worst option as was the case for the Subaru. The Lease option is less expensive than the Borrow option for the Camry and is only slightly more expensive than the Borrow option for the Ford, using the three-year time frame.

If you are indifferent among the three cars, you could also compare the costs among the cars.  For example, let’s say you don’t have enough cash to pay for the car up front, so you are looking at the Lease and Borrow options. The net cost of the Lease option for the Camry is about the same as the Borrow option for the Impreza.  The risk of the Lease option is that you will drive even more miles than you’ve estimated adding to the net cost of the Camry Lease option.  You would want to offset that risk with the risk that you might not get $12,000 for the Impreza when you sell along with the hassle of having to sell the Impreza.

This comparison highlights the importance of getting all of the detailed terms of every option.

Look at All Three Cars – Drive Forever

The graph below shows the same comparison for the “Drive Forever” option.

Other than the total costs of ownership being higher (because you are owning the car until it dies instead of having to replace it or selling it in three years), the relationships among the three options for each car are essentially the same. That is, the order and relative costs of the Cash, Borrow and Lease options are the same for each vehicle.

Of the Lease and Borrow options, the Impreza Borrow option is the least expensive in this example.  The Camry Borrow and Lease options and Ford Borrow option are all $3,000 to $4,000 higher, so you might choose from one of those if you didn’t like the Impreza.  If you have cash to buy the car outright, the Ford Cash option is the least expensive, though the Camry is only a few hundred dollars more.

In addition to comparing different makes and models, you can make similar comparisons among offers you obtain from different dealerships for the same car.

Can I Invest my Cash and Use it to Pay Off my Lease or Loan?

For those of you who read my post about Chris’s mortgage, you know that I suggested he consider paying the minimum payments on his mortgage and investing the rest of his money.  You may be wondering why I haven’t talked about the benefits of investing money under the Lease and Borrow options.

There are a few reasons.

  • Most people who buy a car using a lease or borrowing don’t have the cash available to pay for the car up front. If you don’t have cash to invest, there is no possibility of investment returns.
  • The term of a lease or loan is much shorter than the length of a fairly new mortgage. In Chris’s case, he had 26 years of payments left on his mortgage.  As I discussed in my post on investments and diversification, the likelihood you will earn the average return increases the longer you invest. With the short time span of a car loan or lease, investing in stocks with the expectation of having money to pay off your lease or loan would be very risky.  There is a fairly high probability your investments wouldn’t return enough to make those payments.
  • To avoid the chance that your investments wouldn’t cover your car payments, you could invest in something with very low risk, such as a money market account, certificates of deposit (of which you would need a lot to match the timing of your loan or lease payments) or high yield savings account. Low risk investments currently have very low returns – generally less than 2.5% pre-tax and even less than that after tax.  There are very few loans or leases that have interest rates (implicit in the case of a lease) that are less than 2.5%, so there isn’t much benefit in investing cash in risk-free assets until your loan or lease payments are due.

How To Use the Spreadsheet

To help you create your own comparisons similar to the ones above, I’ve provided you my spreadsheet at the link below.

Overview

The flowchart below will help guide you through the financial aspects of the car-buying process.  It assumes that you have identified one or more cars that will meet your needs and possibly fit in your budget.

The hexagonal boxes in a flow chart correspond to decision points. The rectangular boxes contain action items.

The first step is to determine whether you can afford to pay cash.  If not, you won’t have to negotiate a price for the Cash option for any of the cars you are considering.

Next, take a look at estimates of the up-front and down payments for the Lease and Borrow options.  If you can’t afford either of them in addition to the other costs of car ownership, you will need to find a less expensive option – either new or used – and go back to the top of the flowchart.

The next decision point is how long you want to own the car – the term of the lease (which I have assumed will be three years) or a much longer time (at least as long as the term of the loan in the Borrow option).  When you are done entering the values, you’ll look at the summary at the top of the Lease Term tab if you plan to own the car for the lease term and the Drive Forever tab if you want to own it longer.

If you want to own the car beyond the end of the lease, you’ll need to be able to afford to pay the residual value at the end of the lease.  If not, you’ll want to exclude the Lease option from consideration and focus on the Borrow option.

Collect Terms

Once you’ve narrowed down your choices to a few cars and figured out which of the Cash, Lease and Borrow options work for you, you will be ready to talk to dealers and other car sellers.  The Inputs tab of the spreadsheet lists all of the information you need for each type of purchase.  I defined each of the inputs earlier in this post.  For every deal you are offered, be sure to get all of these values.  I found that there are some of these values that are consistently unavailable if you look on line.  You may need to ask for some of these items specifically.  If you aren’t sure you are getting straight answers, you can always ask for the actual contract.  It is required to have all of the terms.

Enter Values in Spreadsheet

Next, enter all of the values into the Inputs tab.  Then, go to the tab that corresponds to the time period you plan to own your car – Lease Term or Drive Forever.  You can see the total cost of the options for which you entered the data.

If you have deals for more than one car, I suggest making one copy of the spreadsheet for each car.  You can then compare not only between the Cash, Lease and/or Borrow options for a single car, but can compare whichever options are available to you across cars.

Your final choice of car and deal could be the least expensive or a different one. It will all depend on your personal financial situation, your qualitative considerations and their relative importance.  Buying a car is an important decision, so cost may not be the only factor to influence your decision.

Download Car Comparison Spreadsheet