Why Are Car Lease Payments Cheaper than Traditional Financing?

Automobile leasing seems to have gained a reputation for being a cost-effective option for many drivers. The primary reason for this is the significantly lower monthly payment compared to traditional financing. In this article, we will explore why lease payments tend to be cheaper and the underlying financial principles that make leasing an attractive alternative.

Understanding the Differences

A car lease and a traditional loan (or financing) serve different financial purposes. When you lease a car, you do not own the vehicle at the end of the lease term. Instead, you pay a series of monthly payments that cover the depreciation of the vehicle over the lease period. This is fundamentally different from a traditional loan, where you eventually own the vehicle and make payments to fully pay off the asset.

Depreciation and Residual Value

The core concept that makes lease payments cheaper is the depreciation of the vehicle. When you lease, you essentially pay the car's depreciation over the lease term. Here's an example to illustrate the concept:

Example Scenario

Consider a $30,000 car with a normal lease term of 36 months. At the beginning of the lease, the negotiated price (MSRP) is $33,000. The residual value is determined to be 53%, which means the car is expected to be worth 53% of its original value at the end of the lease.

The residual value calculation is:
Residual Value 33,000 x 53% $17,500

During the 36 months of the lease, you are paying off the depreciation of the car, which is the difference between the MSRP and the residual value:

Depreciation $33,000 - $17,500 $15,500

Your monthly payment during the lease term would be calculated as follows:

Monthly Lease Payment $15,500 / 36 months ≈ $430.56

Monthly Lease vs. Traditional Loan

To compare lease payments with traditional financing, consider the same $30,000 car with a 5-year loan term. In this scenario, you would be financing the full cost of the car over a longer period:

Monthly Loan Payment $30,000 / 60 months $500

This is why you generally pay less of the cost of the vehicle during the lease period with a lease compared to a purchase. According to the example, the difference in monthly payments is:

Difference in Monthly Payments $500 - $430.56 $69.44

Over the 36-month lease period, the total difference is:

difference $69.44 x 36 ≈ $2,499.84

Additional Costs Considerations

In a lease, you typically incur an acquisition fee, which is a one-time fee charged by the leasing company. This fee is usually around $900, which translates to an additional $25 per month over the 36-month lease term. Therefore, the effective monthly payment for leasing, including the acquisition fee, would be:

Effective Monthly Lease Payment $430.56 $25 $455.56

While this increases the monthly payment slightly, it is still significantly lower than the monthly loan payment of $500. The net effect of these two items (leasing vs. buying) is a lower monthly cost compared to a traditional loan.

Fossett Total Cost of Ownership (TCO)

Another important factor to consider is the Total Cost of Ownership (TCO). While lease payments may appear lower monthly, the TCO over the entire lease term can sometimes be higher. TCO includes not only the monthly payments but also:

Insurance Taxes and fees Maintenance and repairs End-of-lease penalty fees

In the example given, at the end of the 3-year lease, you have the option to lease a new car, buy the car, or return it. If you choose to buy the car, the car is worth approximately $17,500, which is around 58.3% of its original value. If the loan was structured to pay off the car over five years, the car would depreciate significantly more:

At the end of the 3-year period, the car is worth $20,000. To pay off the remaining balance, you would need to pay around $13,000 over the first three years. During the remaining two years, you would also be making payments on the remaining loan, which totals to $30,000. Therefore, the monthly payments for the loan would be higher than the lease payments.

Leasing provides lower monthly payments, but you need to consider the total cost over the entire lease term. Traditional financing can have higher monthly payments but lower total costs if the car retains value.

Conclusion

Car leasing can indeed provide lower monthly payments compared to traditional financing. The main reason is that with leasing, you only cover the depreciation of the car over the lease period. This is why lease payments are cheaper but also why the total cost of leasing can sometimes be higher. Understanding your financial goals and specific circumstances will help you decide whether leasing or traditional financing is the best option for your needs.