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Learning Center Experience
Bruce R. Kuhlman, PhD, CFA, CAIA, Full-Time Faculty, Kaplan University Published January 2016
You find that you need a car,
but should you lease it or buy it?1 To get to the heart of that
question, you first need to know the mechanics of leasing. Perhaps you have had
a salesperson ask, “Why pay for the whole car, when you can pay just for the
portion you use?” That question seems logical and enticing, but it is also
Ignoring the relationship
between the dealership and the manufacturer, there are three main characters in
an auto lease: the automobile dealership, the lessee, and the lessor. The lessee is the individual taking
possession of the vehicle and paying the lease payments. The lessor is the financial institution that
provides financing for the lease and receives the lease payments. The dealership provides the showroom and
handles the paperwork. This is important...you do not lease the car from the
dealership. You lease it from the financial institution. The financial
institution can be a bank, a credit union, or the financial subsidiary of the
Here is the heart of a lease
that most people don’t fully understand. The lessor effectively purchases the
car from the dealership and then rents it to the lessee. In other words, the
lessor, by providing the purchase price of the auto, has committed its funds to
the transaction. In return the lessor expects to receive a return on the total
amount provided, not just “the portion you use.”
The Lease Payment
The amount of the monthly lease
payment depends on the interest rate,3 the price of the car, the
length of the lease,4 and the residual
value. The effects of these factors are most easily seen in a simple numerical
example. We will use a 36-month, 5% lease on a $40,000 vehicle with a 55%
residual value ($22,000). The thirty-six monthly payments on a lease, assuming
no down payment, would be $631.14.5 With a 6% sales tax, the monthly
lease payment comes to $669.00. If the individual instead purchases the car,
all sales tax is charged at the date of sale. Financing $40,000 + $2,400 tax for
3 years at 5%, the payment is $1,270.77.
The lease payment is
considerably less than the purchase payment, because the lessee repays (finances)
the difference between the price of the car and the residual value, in this
case $18,000, and pays only interest on the $22,000 residual value. In other
words, the lessee is obligated to pay the lessor $18,000 plus interest over the
36-month term of the lease6 and a balloon payment of $22,000 at the
end of the lease. Because the residual value is the agreed upon value of the
vehicle in 36 months, the lessee can simply return the vehicle to satisfy the
balloon payment or pay the $22,000 (plus tax) and keep the vehicle. The
critical fact ignored by most lessees, is that, although the lessee only pays
off the $18,000 decrease in value of the vehicle, each monthly payment also
includes interest on the $22,000 residual value.
A strong motivation for
leasing is that the individual is able to drive a $40,000 vehicle for a monthly
lease payment of $669.00. This payment would only purchase a vehicle worth
Now that you know the mechanics (the
mathematics) of leasing, should you lease or buy? Unfortunately, the answer is
a resounding, yet confusing, yes! That’s because the question isn’t easily
answered by looking only at the numbers. Let’s compare some of the factors
considered in leasing or purchasing a vehicle:
costs vary by manufacturer and may or may not be included in the initial
should be considered a form of financing. As with a financed purchase, a
financial institution has a lien on the vehicle until the contract is settled.
2 Through financial subsidiaries, most auto
manufacturers now offer financing for purchases and leases.
3 The interest rate on a lease, as with a purchase, is
determined by factors such the credit worthiness of the lessee (or purchaser)
and the length of the agreement.
4 The interest rates on leases, as with mortgages and
other loans, typically increase with the maturity of the agreement.
5 This and all other calculations are available upon
6 Each monthly payment on the
$18,000 includes principal and interest. This is equivalent to a fully
amortized loan of $18,000.
By Cynthia Waddell, PhD, CPA, CFE
By Jerry Taylor
By Geoffrey Vanderpal
By Dr. Denise Schoenherr
By Stanley W. Self, CFE
By Rachel Byers, Full-Time Faculty, School of Business
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