$802.50/month…or $429.00/month?

With low monthly payments, lease offers can sound too good to be true. It’s smart to be skeptical, but an analysis of the numbers reveals that leasing can have distinct advantages over a financed purchase.

Photo: $802.50/month…or $429.00/month? 0
October 30, 2012

If you’ve ever contemplated buying a new BMW, you’ve probably also considered whether to lease rather than purchase it outright. Plenty of automakers, BMW included, offer lease deals with surprisingly low monthly payments—so low, in fact, that they can seem too good to be true, making some customers suspicious about their real cost.

Is leasing merely a more expensive way to finance a new-car purchase? Both lease and purchase transactions involve a contract that includes interest and other fees to compensate the finance company for the use of funds, but what are those amounts, exactly? It’s hard to tell at a glance, since the leasing companies aren’t willing to reveal the finance rate, but there are ways to calculate the true cost of leasing in order to compare it with an outright purchase.

We’ll get to the math in a moment, but first let’s discuss the nature of a car lease. It isn’t like the lease on an apartment, in which you pay a monthly rent and acquire no aspects of ownership. With a car lease, you have all the attributes of ownership even though your name isn’t on the title unless (or until) you pay the residual value at the end of the lease. In that sense, a lease isn’t very different from a purchase transaction that is financed; in that case, you are the titled owner but the finance company has a lien on the vehicle that limits your ability to transfer title. A lease and a purchase transaction also have numerous differences with respect to your rights and liabilities, which we’ll address later.

Now let’s analyze the financing costs, using an example from the BMW North America website, which offers financing through its captive finance arm, BMW Financial Services, whether the vehicle is leased or purchased. Bear in mind that although these figures were accurate when this was written, they are subject to change at any time and thus should be used for reference only.

We selected a 328i xDrive Coupe with an MSRP of $44,895.00 on which BMW offers an enticing 2.9% finance rate on a five-year loan for a purchase. With zero down, monthly payments would be $802.50 per month.

For a three-year lease with 10,000 miles allowed per year, BMW shows the following data:

MSRP $44,895.00

Cash due at signing:

First month payment 429.00

Down payment 2,500.00

Security deposit 0

Acquisition fee 725.00

Total $ 3,654.00

Disposition fee 350.00

Residual value

(Purchase option) $29,182.00

At just $429.00, the monthly cost to lease a car is considerably lower than the payments on an outright purchase of the same car, but bear in mind you’re paying for a smaller portion of the car over the three-year lease term than in the first three years of the purchase agreement. A straight comparison of lease payments to loan payments gives a misleading result, therefore, since the loan payments include a greater amount of principal. To compare a lease to a purchase transaction, you must determine which amounts in the lease are equivalent to payments of principal and interest. The principal is easy to calculate, as it is the difference between the purchase price and the residual value:

Purchase price (MSRP) $44,895.00

Residual value ( 29,182.00)

Principal payments $15,713.00

Any other amounts can be classified as finance charges. The total amount to be paid during the term of the lease is $19,019.00 as follows:

Down payment $ 2,500.00

Acquisition fee 725.00

36 lease payments ($429 each) 15,444.00

Disposition fee 350.00

Total amount paid $19,019.00

The difference between the total amount paid ($19,019.00) and the principal paid ($15,713.00) is $3,306.00, which represents the finance charges in the lease transaction.

So what’s the finance rate on that lease? Although it won’t be quite as accurate as the sophisticated software used by the leasing company, an easy calculation will provide our answer. First, we have to break the lease into two separate loans. One loan requires payments of principal and interest to bring the balance owed down from the MSRP of $44,895.00 to the residual value of $29,182.00. The second loan pays only interest on the residual value of $29,182.00:

Purchase price (MSRP) $44,895.00

Principal payments ( 15,713.00)

Residual value $29,182.00

The finance charge on the interest-only loan of $29,182.00 is simple to calculate, since the balance of the loan stays the same throughout the lease term. The amortizing loan, which requires payments of principal and interest, has a constantly changing principal balance and each payment represents a slightly different combination of principal and interest. The early payments have a higher proportion of interest than the later payments and the principal payments move in the opposite direction. The magic number is the one in the middle. Since the amortizing loan starts with a principal balance of $15,713.00 and declines to 0 at the end of the lease term, the average of these two numbers is the average principal balance outstanding during the lease term:

($15,713.00 + 0) /2 = $7,856.50

This is the average principal balance on the amortizing loan during the lease period, and it can be added to the principal balance of the interest-only loan to get the average principal balance of both loans:

Principal balance of interest-only loan $29,182.00

Average principal balance of amortizing loan 7,856.50

Average principal balance during lease term $37,038.50

Our total finance charge for three years is $3,306.00 or $1,102.00 per year. Dividing $1,102.00 by $37,038.75 results in a finance rate of 2.98%. This isn’t a perfect calculation because lease payments are in advance and loan payments in arrears and a larger payment is made at the initiation of the lease, but it is quite close. A more exact calculation would likely give us the same 2.9% rate offered on a purchase.

Those low monthly payments: Too good to be true, or good business sense?

To a lot of customers, that sounds too good to be true. Why would a manufacturer offer the same rate on a lease when there’s a good chance it will have to dispose of the car at the end of the term, assuming you don’t exercise the purchase option? Because it makes good business sense.

According to BMW Financial Services, about half of all new BMWs are acquired with a lease and half with a purchase. Their experience shows that lease customers are more likely to be repeat customers who drive away in another new BMW at the end of the lease term.

Leasing also provides auto dealers with a quality group of used BMWs to offer through the Certified Pre-Owned program. CPO cars are a very profitable segment for most manufacturers, as the dealer makes a profit on the car and the manufacturer profits from the warranty.

Of course, the leasing company incurs a risk, as well, mainly that it will set residual values too high. BMW has to calculate residuals at the time the lease is written, but the customer can assess the car’s market value when the lease expires, putting the customer at an advantage come expiration day. If the value of a leased BMW sinks more than expected and it’s worth less than the residual value, BMW will take a hit unless the customer chooses to buy the car at the end of the lease term. Here, of course, it helps to know the car’s actual value and to compare it to the residual: If it’s worth less, exercise your “put” option and give it back to the leasing company. If it’s worth more (or you love the car and don’t want to part with it), you can buy it for the amount stated, even if that’s less than the car’s true market value.

How does BMW calculate residuals? BMW Financial Services wasn’t willing to provide specific information, but we can assume that the estimated value at lease end represents the company’s best guess of the car’s wholesale value, allowing a satisfactory profit on resale. Even if BMW’s estimate proves correct, buying the car for its residual value at the end of the lease term represents a bargain, because you’d be paying wholesale, not retail.

BMW Financial Services told us that the residual value for a particular model is a fixed percentage of the original cost, including options. Since you negotiate the price of a leased car just as you would one that’s purchased, any discount from the MSRP translates into lower lease payments and a lower residual.

If you lard the car up with options, a lease might afford further advantage if you plan to dispose of the car at the end of the lease: Those expensive options that inflated the price of a new BMW do not represent nearly as much value when the car is for sale on the used-car market, yet under BMW’s calculation of residual value, the options depreciate at the same rate as the car.

What about tax deductions? Does a lease have an advantage over outright purchase? The simple answer is no. While the IRS tax rules dealing with business use of a car are needlessly complicated, they are clearly intended to provide the same results from either transaction. The portion of expenses deductible is strictly limited to the percentage of qualified business usage. With an outright purchase, those expenses consist of depreciation, interest on the loan, operating costs and maintenance. With a lease, your lease payments take the place of depreciation and interest.

In either case, the test for deductibility is exactly the same, although the amounts can vary somewhat from year to year. An outright purchase affords one advantage in that you can accelerate your deduction under Section 179, but that only shifts a portion of the deduction to an earlier period and doesn’t affect the total amount deducted.

It should also be noted that the IRS limits deductions for higher-priced cars. Although there are separate limits for leased cars and purchased cars, the purpose is to make the two types of ownership equal for tax purposes. The simplest way to account for business use of a car is to use the IRS standard mileage rate for business mileage, which would provide the same deduction in either case.

Leasing: Your rights and responsibilities

Leasing involves another consideration beyond the numbers: What happens if a Prius driver is busy texting and plants their vehicle in your trunk? Even worse, what if they’re insured by one of those companies with clever TV advertising but a lousy reputation for making fair settlements, and they offer you less than you need to pay off the lease on your now-totalled BMW?

For that eventuality, you’ll need “gap” insurance. BMW includes gap insurance in your lease agreement, but you need to be aware of this potential liability nonetheless, which also exists if you own the car. (In that case, you would be on the hook for any difference in value.)

A lease agreement might require you to buy higher levels of insurance coverage than you might typically purchase. For example, if you typically choose a $1,500 deductible on your collision insurance and the lease agreement requires a $500 deductible, this requirement will increase your insurance premium.

Speaking of repairs, what of the little things, things like door dings? If you’re considering a lease, you’re probably worried that you’ll be penalized by hundreds of dollars for those two or three minor dings inflicted by thoughtless other drivers in the parking lot. Fear not: Simply measure the size of the dent with the Ding-o-meter provided by BMW and you’re home free for most small dents. Those under 2.0 inches are accepted at “no charge,” by BMW. This was a shock to me, as I assumed the leasing company would use this to add some extra profit to the lease transaction. BMW’s approach seems quite generous.

Tires are another consideration, as BMW requires the car to be returned with tires whose tread depth measures at least 1/8-inch. Bear in mind that you might need to replace the original tires before you return the car, as it’s not likely that the originals will last for three years and 30,000+ miles.

What about mileage? Lease agreements with low monthly payments usually allow only 10,000 miles per year. This can be adjusted at the initiation of the lease, though allowing for more miles will reduce residual value and increase monthly lease payments. Upping the mileage to 15,000 per year increased the cost of one lease by $0.08 per mile or $32 a month for a total of $1,152 over the three-year term. Those extra 15,000 miles paid for at the end of the lease, on the other hand will cost $0.20 per mile for a total of $3,000—unless you exercise your option to purchase the car, which affects the economics of the lease as it requires either a lump sum or a new loan to complete the purchase. Adding more miles to the lease will also reduce the car’s residual value, as a higher-mileage car will be worth less.

Making the choice: Six things to consider

If you’re still with us, you realize there’s no easy choice to be made between buying or leasing a new car. We can, however, suggest you ask yourself a few questions to help determine which is best for you.

1. Calculate the finance charge rate in the lease. If the rate is about the same for both transactions, a lease offers some advantages over a purchase. If the used car market is soft at the end of the lease term and the car is worth less than the residual amount, you can return the car.

2. If you expect to keep the car at the end of the lease and can get a favorable interest rate on a loan with a longer maturity than three years, a purchase might be advisable. Interest rates are currently at historic lows, but they are almost certain to rise as the economy revives.

3. If the lowest possible monthly payment is important to you, the lease is probably the best option. If you’d welcome a dose of fiscal discipline, the higher payments that usually accompany a purchase will force you to pay off the loan faster.

4. If you have cash in the bank that is currently accumulating interest at less than 1% and you don’t need it for a financial reserve, consider purchasing the car outright with no loan or lease. Even if you finance the car with an interest rate of 2.9% or lower, you’re losing money overall because you’re currently getting less than 1% on your savings.

The tax consequences increase your loss further, since the interest paid on the car loan is not deductible (except for the portion that can be allocated to business use of your car), while the minuscule interest income on your savings is subject to income tax.

5. Consider the mileage factor and your expected use, especially if you have plans to turn the car in at the end of the lease. If the car has considerably fewer miles than allowed under the lease, you haven’t made use of the miles you have paid for. If the car has more miles than the lease allows, you’re subject to a penalty.

In either case, especially with a strong used-car market, you would be wise to exercise the purchase option and sell the car yourself. You might negotiate with the dealer if you are planning to replace it with another BMW, as he might allow an adjustment to the new car to compensate you for the loss.

6. Do you plan to modify the car? Unless the mods can be reversed, you’re better off purchasing rather than leasing, as BMW will require the car to be in original condition if you return it at the end of the lease.

It sounds like an advertising cliché, but there’s never been a better time than now to buy a new automobile. Low interest rates mean the cost to borrow money has never been lower, and that’s true whether leasing or purchasing a new BMW turns out to be the right decision for you.

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