When it comes to purchasing a vehicle, most people need to consider their financial situation and weigh the pros and cons of an auto loan versus an auto lease. Both options have their advantages and disadvantages, so it’s important to understand the key differences between them and the criteria you should consider when making your decision. Everything from the amount of cash you have on hand for a down payment, your long-term goals, and your estimated mileage come into play when making this decision.
In this Money Chat, we will help you understand what the key differences between an auto loan and an auto lease are and what to consider when deciding between the two different purchasing options.
What are Auto Loans?
An auto loan is a type of financing that allows you to borrow money from a bank or other lender to purchase a vehicle, using the vehicle as collateral. This is the most common way to purchase a vehicle, and the one most often depicted through commercials, movies, and television.
Auto loans are typically repaid in monthly installments over a fixed period of time, usually three to seven years. When you take out an auto loan, you are paying down the loan amount with the intent of owning the vehicle outright, and you’re responsible for maintaining it and paying for repairs and maintenance. Most loan agreements come with warranties that cover anywhere from two to ten years of maintenance. However, the biggest staple of the auto loan is that when the loan is fully paid off, and your bank/loaning institution transfers the car title to you, you are in full legal ownership of the vehicle.
Think of an auto loan as purchasing a house. Once you begin your mortgage, or in this case, auto loan, you are the primary owner of the vehicle.
Criteria to consider for auto loans:
Down Payment: When you take out an auto loan, you’ll typically need to make a down payment, which can range from a few hundred dollars to several thousand dollars. A larger down payment will reduce your monthly payments and the overall cost of the loan.
Let’s say you purchase a vehicle for $25,000—the average cost for a mid-sized sedan. If you took out a loan for the entire amount, plus interest and taxes, your monthly payment over a five-year period would be roughly $500 per month. Now, if you put just $5,000 down on this loan, your monthly payment would be $400.
Interest Rates: Auto loan interest rates can vary depending on your credit score, the length of the loan, and the lender. A higher credit score will usually result in a lower interest rate, which can save you money over the life of the loan. Deciphering exactly what your interest rate will be can be tricky, and usually won’t be made clear until you are at the car dealership, but understanding the importance of a high interest rate can make or break your auto loan decision.
Let’s say you are in the same scenario purchasing a vehicle for $25,000. If your interest rate is 4.5%, which is a very good rate in today’s high-interest market, your loan would come out to the above rate of $400 a month with $5,000 paid at signing. With very bad credit (a very low credit score), your interest rates can climb up to 10-15%. If you tried to pay the same above loan at a 10% interest rate, your monthly payments would become $470. Over the lifetime of that five-year loan, that equals out to roughly an extra $4,000.
Monthly Payments: Your monthly payments will depend on the amount you borrow, the interest rate, and the length of the loan. A longer loan term will result in lower monthly payments, but you’ll pay more in interest over time. Monthly payments are typically the most important aspect of the auto loan, but be wary of signing longer-term loans. While most auto loans are five to six years, it isn’t unheard of to be offered a seven or eight-year loan to bring your monthly payments down. While this helps you in the short term, it could lead to paying thousands more in interest.
What are Auto Leases?
On the other hand, an auto lease is a type of contract that allows you to rent a vehicle for a set period of time, usually two to four years. When you lease a car, you don’t own it outright, but you’re responsible for maintaining it and paying for any excess wear and tear or damage when you return it at the end of the lease term.
Think of an auto lease like renting a home. While you have full control over the property, and your family lives in peace inside the home, you do not outright own the property and at the end of the term you will have to pay for any excess damage you did.
Criteria to consider for auto leases:
Monthly Payments: When you lease a vehicle, your monthly payments are typically lower than they would be if you took out an auto loan to buy the same vehicle. This can make leasing an attractive option for those who want to drive a new car every few years without a high monthly payment. Auto leases are typically lower monthly payments because you’re paying only for the vehicle’s depreciation during the lease term, plus interest charges, taxes, and fees.
Essentially, where auto loans are set fixed amount loans you pay over time, auto leases are calculated based on what the dealership believes they can sell the car for at the end of your lease term—either to you or to someone else.
Mileage Restrictions: Because the lease terms just cover the cost of depreciation, most auto leases come with mileage restrictions, which can range from 10,000 to 15,000 miles per year. If you exceed the mileage limit, you’ll be charged a fee for each mile over the limit, which can add up quickly.
It is vitally important to consider vehicle usage before you make a final decision. Do you commute to work? Do you take long road trips? Do you anticipate moving across the country? These factors play into whether you will be able to maintain the mileage restrictions placed on your leased vehicle. Consider tracking your current car mileage over the course of a month, and extrapolating that data over the course of a year by multiplying it by 12.
Damage Costs: When you return a leased vehicle, you’ll be responsible for any excess wear and tear or damage, which can result in additional charges. You’ll also be required to maintain the vehicle according to the manufacturer’s recommendations, which can be costly.
Think of this step like moving out of a rented apartment or home. While the management company will typically not charge you for any holes from hung artwork, or rug damage from walking on it every day, they’ll consider charging you to fix any broken fixtures, or replace any destroyed blinds in the apartment. For a leased vehicle, normal wear and tear in the interior of the car is expected. But if there are any major dents, scratches, or mechanical issues, you may be on the hook for the repairs.
Should you get a loan or a lease for a car?
The decision to lease or buy a vehicle will depend on your individual needs and financial situation. If you plan to keep the vehicle for a long time and want to build equity in it, an auto loan may be the better option. If you prefer to drive a new vehicle every few years and don’t mind the mileage restrictions and potential fees associated with leasing, then leasing may be the better choice. The key is to sit down and consider these criteria before you make any major purchasing decisions.
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Understanding the differences between auto loans and auto leases, and the criteria to consider when making your decision, can help you make an informed choice that fits your needs and budget.
Visit Receivable Info’s Money Chat series to learn more on other financial literacy topics. There are dozens of free, easily accessible financial education resources for consumers to explore to avoid uncertainty as they navigate debt. If you want to learn more about financial literacy or your rights as a consumer, please visit the Receivables Info Resources Page.
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The information contained in this article is meant to serve as general guidance for consumers and not meant to serve as comprehensive financial advice. For questions about your individual circumstance, finances, or accounts, please contact your creditor(s) and/or financial advisor directly.
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