I decode the jargon used in the industry and walk you through the best methods to get that new ride.
Buying is a car is usually the second largest purchase you make in your life, after a house, and for a large portion of the population it’s a clear necessity. This is especially true if you live somewhere where public transport is not easily accessible. So, gripped with the reality of needing a car, most people tend to go to their local dealership and end up leasing or financing their vehicle. While these methods themselves aren’t inherently wrong, the way most Americans structure their finances around car buying is what creates massive bumps on the road to building wealth and financial freedom. What I want to achieve in this post is to review the most financially sound ways you can get your next car given certain scenarios, and walk you through why I feel like these are the best options. Before I continue however, I think it’s first important we discuss what leasing and financing are and what each option looks like as a financial product. I will try and keep this as user friendly as possible as it’s really easy to get lost in the jargon. So, let’s begin.
What is Leasing
Leasing is a financial product that allows you the flexibility of upgrading or swapping one car out for another at the end of a given term. It was created as another way to "buy" a car without ever fully owning it and it’s also worth noting leases are a bit easier to get approved for. In a nutshell though, its long-term renting. You keep the car for a certain number of months and you can only drive it “X” number of miles in that time period. The contract terms for a lease vary but the industry average is a 36-month time period with a 12,000 mile per year allowance. At the end of your term you simply hand the car back over to the dealer and walk away. When quickly comparing leasing to financing, you also notice that it is usually cheaper to lease a car than to finance it on a monthly basis and this is possible for a few reasons. When you start reading the details of the contract and take a look at the numbers you find out that leasing a car is broken down to a simple equation that involves 5 key items: the purchase price of the car, the interest rate (for leasing it’s called the money factor), the residual value of the car, the term of lease, and the depreciation of the car. The purchase price is simply the price of the car and this number is the only thing you can really negotiate since this is the key driver of what your monthly price will come out to. The money factor is the interest rate that’s charged for you to take out the lease, because the loan administrators want to make some money off this transaction, and it is dependent on your credit score. The residual is the value of the car at the end of the lease term. This number you have no control over as the manufacturer comes up with this number using complex formulas and historical figures. As you can guess, the term of lease is how many miles you want to drive over a period of time. And the depreciation is how much value the car loses over time. This number is important since it's the main figure used in calculating your monthly payment. Depreciation is calculated by taking your purchase price and subtracting it from the residual number (purchase price – residual = depreciation). When you take that depreciation figure and divide by how many months you will lease, that gives you your base monthly payment amount (depreciation / number of months = base monthly payment). To get your final monthly figure, you take your newly found base monthly payment and add the interest rate on and voila your final monthly payment is calculated. Your monthly payment is affected by 1 force alone. The purchase price. Since the auto manufacturers know how much the car will be worth at the end of the lease and the interest rate is set by the bank, the lower you can get the purchase price, the better your monthly payment will look. You can lower this number in 2 ways. Either you negotiate the purchase price down or you make a down payment. The preferable way is to get the price of the car lowered as any money you put as a down payment is money you will never see again.
What is financing
Financing on the other hand is a little simpler than leasing. It’s a loan product given to those who choose to fully own their vehicles at the end of the financing term and can’t afford to or don’t want to pay for the purchase price of the car up front. The industry average of the financing deals typically tend to be 60 months, A.K.A 5 years, and an interest rate in the neighborhood of 3-4% for people with good credit. Obviously, there are no limitations to mileage as you’re paying for the car to gain full ownership at the end of the term. As compared to leasing, the monthly payments tend to be higher as you are now paying for the full cost of the car and simply not just the deprecation value over time in a lease. Now let's get into the mechanics and the numbers for a financing.
The 3 key numbers to remember are purchase price, the length of time you choose to pay the car off and the interest rate. The purchase price is what you are willing to pay for the car, the length of time is how long you choose to pay off the car and lastly the interest rate is rate the bank wishes to charge you for that loan and is highly dependent on your credit. Typically, this is how it adds up: purchase price / term of loan = base monthly payment. Now add in the interest rate on top of the base monthly payment and you get your final monthly payment. Simple enough. The numbers which should be paid close attention to are the length of time for the loan and the final purchase price.
The final purchase price can be negotiated to be lowered with a down payment, same as with a lease. However, unlike a lease, putting more money into the down payment for a financed car will go towards the eventual full ownership of the vehicle, so in this case you’re not throwing money away. You want to pay attention to the length of time for the loan as this does impact the monthly cost. Basically, the longer amount of time it takes to pay off the car, the lower the monthly payments will get. I will touch more on this later but remember these key items for now.
Okay so now that we know the what leasing and financing are, I want to tell you when each option is optimal given a certain situation. Little hint however, there are only a limited number of scenarios (almost only one exact scenario for each option) where either choice is acceptable. Let's get into it.
Scenario one: I want to have a new car every so often so leasing makes sense for me, right?
I get it, cars are sometimes a thing of stature and social representation, so let's assume you want to keep swapping into a new ride every so often. How do you achieve this without being a financial nincompoop? The answer is to build up your assets to a level where the assets are paying for your toys. I don’t want to get into the creation of wealth per se with this post but what I'm trying to say if that if you diversify your income stream to a point where you have many avenues from which money is coming in, I don’t see how why you wouldn’t be able to keep your car swag rolling along. The goal however is to keep certain assets dedicated to pleasures while the majority of your assets are geared towards building up your wealth. I would say if you could dedicate 10% of your income towards car pleasures per month and the rest towards other items, that would be ideal.
Again the key to making this work is stockpiling enough assets first so that you can dedicate a certain income stream towards the pleasures in life. This is also the ONLY time leasing a car makes sense. I would refrain from personally leasing a car at all costs. If you are just blowing your earned income (A.K.A. the money you receive as a paycheck from your employer where you work hard every day), you are literally throwing money into a fire pit for no gains of any kind. Instead that money could be saved up to build other income streams. One major thing to note. Cars are depreciating assets, meaning they lose value over time. When you lease a car personally, you are literally paying for the car to depreciate with nothing to gain at the end. That is something you should not do with your earned income.
Scenario two: Okay, I don’t own any money generating assets to lease a car, but I need a car now and have $5k saved for a down payment.
If you are in position, where you only have an actively earned income and have saved up some money for a down payment, I would say go out and buy a quality used car. I know this is probably not the answer you were expecting, but hear me out for a second. What I would do is take the $5k and buy a used car in cash, but I would continue to pay myself the monthly amount it would cost me to finance a new car. If you do this you can start rolling the scenario out in your favor. Here’s an example, let's say you buy that used car for $5k and you continue to pay yourself (put aside) $500 per month even after you bought your $5k car over a period of 2 years. After 2 years have passed, and accounting for some depreciation you now own a car that is reasonably worth $3.5k - $4k, after driving it about 12k miles a year, and you saved up another $12k from the $500 you paid yourself every month, you collectively will have around $15.5k to $16k. Now you can go buy another quality used car for that amount. Let’s take it another step further and say you do this again after purchasing this second used car. After another 2 years you will have a car valued around $14k and another $12k in cash on hand. You can trade up and pay cash for a $26K car. See the snowball effect. The coolest part, is that you never took out a loan and cycled thorough 3 different cars over 4 years. All you need to do in this situation is adjust the numbers to fit your financials.
Scenario three: I don’t own any revenue generating asset and I currently own a really old car but I don’t want swap into a used car since I need a reliable car to drive to work. Also, I have very little to spare from my savings.
This is a tough situation to be in and I find that most people who go to buy or lease cars are sort of in this realm. The best strategy in this situation is to pay yourself monthly whatever you can and try your best to look for a quality used car you can purchase. If you can come up with around $415 a month within 2 years, you'll be very close to $10k to buy a good used car. As a last resort and again I don’t really recommend this, you can save up some cash to put to a down payment and finance a new car. However, I would say there are two things that would be really important to look out for assuming you wanted to go this route.
First, make sure you can follow 48/20/10 rule. Whichever car you decide on, you should only finance the car for 48 months or under; if you can't afford the car within 48 months, you shouldn’t buy that car as it’s likely too expensive. Make sure you can pay down 20% of the negotiated purchase price as the down payment, this will help you out a bit with affordability of the car on a monthly basis, and finally keep the monthly payments to 10% of your net (post tax) monthly income or under. I would add onto this and see if you can get qualified for an auto loan under 3%, preferably 0% if it can happen. This would mean you need to check if your credit it in order to qualify as that’s usually a prime rate. If you can follow the 48/20/10 rule that would be best and if you can get close to 0% for the interest rate that just icing on the cake.
Other items to note
Another thing to keep in mind when financing a car is that you need to remember that cars depreciate the most within the first 3 years. Afterwards the depreciation is less steep. On average you are looking at losing close to 25% as you drive off the lot and close to 48% over the next three years. That is why I recommend quality used cars that are 2 or 3 years old as you won’t be taking the massive hit of the initial depreciation and the car has little that can go wrong with it within those first few years. Not to mention certified pre-owned vehicles are coming with amazing warranties nowadays. If you opt for an EV (Electric Vehicle), aside from helping save the planet, there’s even less that can go wrong with them. Since there are only a few moving parts on EV’s, they require little to no maintenance to keep them running. Anyway back to financing.
If you must buy, just remember even if you pay cash for that new car it will immediately be worth a whole lot less just taking it off the lot. It's just something to keep in mind. However, if you have that kind of money where you can pay cash for new cars and keep swapping out every couple years, props to you. It's just that you are throwing a lot money away. But if that is your lifestyle, who am I to stand in your way. If anything, if you possess that much cash, I would say why not lease your cars and make your assets pay for them because I would assume with that kind of money you must be making it from your businesses or other assets. If you lease cars through your business(es), you can probably write them off as a business expense and that would work way more in your favor. I won’t get into that too much in this post but that is honestly what I would do.
To wrap things up, my advice to most people is really to try and pay cash for your rides. Try to buy quality, low mileage used cars with money you have saved up and continue to pay yourself every month and trade up to a newer car every few years until you get to a point where you are comfortable keeping the last car you bought for an extended period of time. For people with revenue generating assets and businesses that want to spoil themselves a bit and actually like cars, I would say lease your cars but make sure those assets are paying for your toys, then write them off as business expenses. And lastly, for people who simply have no choice and need to finance a car stick to the 48/20/10 rule and, if possible, attach that to a loan with a 0% interest rate.