A few weeks ago, I wrote about the dangers of negative equity—or owing more for your car than it’s worth—and how most people end up being “buried” in their automobile because they put very little or no money down and finance for the longest term possible when they buy it. So how can we avoid this awful fate?
There are four ways. The first is to buy a car that actually goes up in value. In other words, a classic car. So, just go out and find yourself a nice, low mileage, numbers matching 1970 Plymouth Barracuda with a 426 Hemi. I guarantee you, you won’t be upside down when you decide to trade it in.
OK, we all know that’s not practical or advisable. You’d ruin a car like that driving it on a daily basis. That leaves only three ways to minimize the effect of negative equity. The first is simply to pay cash. If you don’t owe anything on it, you don’t have to worry as much about what you’ll get for it when you trade it in. Of course, you’ll never get back what you paid for it, so there’s still a loss of equity, but at least you won’t have to deal with three or four grand left on your loan on top of that.
However, the average cost of a new car these days is $33,560. Who has that kind of plata sitting in the bank? Not me! That means we’re down to two ways to avoid negative equity unless you want to buy new. In that case, there’s only one.
Yup, there it is. I used the “L” word. Normally, when you’re talking to a customer and you mention the word “leasing” that’s the end of the entire conversation. It goes something like this:
SALESPERSON: “Well, have you ever considered lease—”
CUSTOMER: “Nope, no, no, not gonna do it! I’m not interested in leasing.”
They won’t even let you get the word out of your mouth before they tell you no! That’s how strong the resistance to leasing is. And the main reason people have such resistance is, first, they’ve heard a bunch of horror stories about leasing, most of them based on practices that were common 20 years ago but aren’t allowed today such as massive “balloon payments” at the end of a lease.
Second, people simply don’t understand it. And people fear what they don’t understand. You might say leasing is the “James Dean of Automobile Financing.” It’s totally misunderstood by the general public, mainly because of unfamiliar terminology such as “residual,” “capitalized cost reduction,” and so on. I’m going to try to explain leasing in a way that minimizes the confusing terminology because once you get past that you’ll realize that leasing really is the best way to buy a new car.
How does leasing work? In order to understand that, first let me explain how conventional financing works. In conventional financing, you take the entire price of the car, add taxes and fees, subtract any down payment, and then plug in a term or how long you want to finance the vehicle. These days, more and more people are opting for six years, or 72 months, just to get their payments to a level they can tolerate. Your monthly payment is the total cost of the car, divided by the number of the months in the term, multiplied by an interest rate.
Leasing is a little bit different. When you lease, you don’t pay for the whole car. You only pay for the portion you use. To determine that, the first thing the manufacturer does is take the price of the car and, using historical data and a mathematical formula, comes up with a figure that represents what they think the car will be worth after three years of depreciation. That’s called the residual value. You don’t pay for that part. You only pay for the price of the car minus the residual, minus any down payment, plus taxes and fees.
Let’s say you’re looking at a $30,000 vehicle. (I’m going to use round numbers here to make it easier.) After three years, depreciation usually takes away anywhere from 45 percent to 60 percent of the value of a new car (ouch!). To make it simple, let’s just say you lose approximately half the value of the car in three years. That means the amount you’ll lease the car for is $30,000 divided by two, or around $15,000. To get your monthly payment, you take $15,000, divide it by the number of months in three years—36—and multiply that by a tiny amount of interest, called the money factor. That gives you your base monthly payment—the one they advertise in all the “lease specials.”
At the current time, a good money factor is something like .00015. To convert a money factor into an interest rate, multiply it by 2,400. In this example, .00015 X 2,400 = .36% Not as good as 0%, but less than 1% and far lower than you typically get in conventional car loans.
There are a few small fees to be considered when leasing, such as an “acquisition fee” and a “disposition fee,” but these are usually only a few hundred dollars each. Of course, you still have to pay taxes when you lease, but the taxes aren’t paid up front, they’re included in the monthly amount. So on a $30,000 car with an advertised lease of $269 per month, expect your payment to be around $300 a month once all is said and done (taxes are never included in national ads because taxes vary depending on where you live). And that’s it. That’s all you’re paying for the pleasure of driving a new car for the next three years.
Best of all, you’ll never have to deal with negative equity again
At the end of a lease you have three options. If you really like the car, you can buy it. And you’ll know what you can buy it for at the start of the lease because it’s written into the contract. Second, you can trade the car in, just like you would any car. Third, you can hand the dealer the keys and walk away. So, in case you haven’t figured it out, leasing is more like renting an apartment than buying a home. The reason this makes perfect sense is, apartments and cars depreciate in value rather quickly, while homes typically appreciate in value over time. And almost every financial expert you talk to will tell you never to finance a depreciating asset because you’ll never see a return on your original investment.
Now, the first objection most people make when they hear all this is “Hold on, Mark, I don’t want to rent a new car. I want to own one.” I understand. Ownership is a very powerful motivator for a lot of people. But think about it. If you’re financing a car for six years, do you really own it? If you want to see who owns your vehicle, skip a few payments. When it disappears from your driveway, you’ll find out who the real owner is. It’s the bank. No one owns a car until it’s completely paid off. But how many people keep their car six, seven, eight or more years? There are some, but not many. Most people get tired of their ride and trade it in after four or five years. So the truth is, most people never actually own their cars. They’re already renting, they just don’t see it that way. They’re also paying more interest than they need to, and if they decide to trade before they’ve paid it off they usually have a huge pile of debt left over, which gets tacked onto the price of their next vehicle. Does that make any sense?
With leasing you get the freedom of a brand new car every two to three years (which is always under warranty), you can drive a car with a lot more features for far less money, you pay practically zero interest, and every lease comes with GAP insurance, or Guaranteed Asset Protection, included. So if someone T-bones you at the intersection and your car gets totaled you don’t have to worry about paying it off. The manufacturer does it for you. Best of all, you’ll never have to deal with negative equity again.
Is there a down side to leasing? Only a few, to my mind, and one isn’t a downside if you’re fully aware of it at the start. First, there are mileage restrictions with a lease. Usually, you’re limited to 10,000 or 12,000 miles per year. And if you go over that you pay a few cents per mile at the end of the lease. However, if you know you’re going to be driving more you can tailor a lease to accommodate your driving habits—up to 100,000 miles a year with some manufacturers—and pay no penalty at all. Next, you need good credit to lease (a score of over 700). Finally, you won’t be able to keep that baby until the wheels fall off. And you can’t customize it. Drat.
Here’s something else to consider: almost everyone who works in the car business leases their cars. Very seldom will you run into a person in sales who finances a vehicle the traditional way. That’s because they’ve seen what negative equity can do, and they understand that at the end of the day, after the shine wears off and the new car smells goes away, new cars are really only big chunks of depreciating metal. So why invest all that money when you’ll never get it back?
There’s one last way to avoid negative equity—and it might be the best way of all. Buy used. Preferably Certified Used. We’ll talk more about that in the future. Thanks for reading!