One of the biggest decisions customers must make when financing a car is to lease or take on a loan. Let us first understand the differences and then discuss the benefits of both.

The biggest mistake people make when comparing a lease versus a loan is thinking that depreciation - the largest cost of a monthly lease payment - is different. They are exactly the same in both cases. It is important to first understand depreciation.

Whether you take on a loan or create a lease, your car is still going to depreciate at the same rate. This means that if your car is worth $20,000 when you buy it, and then $7,000 in 5 years, you still had to pay for the $13,000 that was depreciated over the term.

Here is where the difference between a loan and a lease really come into play. In a lease, you only pay the depreciation of the car throughout the term of the lease. In a loan, you pay the depreciation plus the additional principal that is required to pay the car of within the five year term (or whatever you choose). Do not forget that in both cases you are also paying the interest payments as well as taxes.

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In order to pay off a loan within a given period you need to divide the cost of the vehicle by only five years. In a lease you only pay the depreciation of the vehicle, not the entire price.

Because you are paying the entire balance of the cost of the car in a loan, you own the car at the end of the term. This also causes the payments to be much higher in a loan than in a lease.

Remember, even though you own the car at the end of a loan, you still lost the same amount of value in the vehicle as if you had leased it. The only reason you own the car at the end of a loan is because you paid the extra money each month to pay off the principal balance.

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Much like a home mortgage, in a loan scenario, your monthly payment includes much more interest per payment at the beginning of the loan than at the end. A lease, however, charges the exact same amount of interest in each payment.

Because of this, you may find yourself “upside down” in a loan for the first couple years because you are not paying off enough of the principal cost of the car during the beginning of the term. Loans are designed to pay lenders “up front” because you are not obligated to continue the loan through the entire term. Leases, on the other hand, require you to pay a fixed amount for a fixed period of time, and therefore leasing companies can charge customers in a different manner.

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At the end of a lease you do not own the car, but you also did not have to pay the extra money each month during the term of your lease. If you want to own your car at the end of a lease, you can easily do so by purchasing the car at the Residual Price. Keep in mind that you can purchase a vehicle at lease end if you really want to keep it.

The difference between a loan and a lease really comes down to how you want to use the additional money. Do you want to invest it in your vehicle or do you want to invest it elsewhere, such as a mutual fund or an interest-bearing account? Most people who opt to pay the money through the course of a loan do so because they are not comfortable managing that extra money elsewhere, and therefore they prefer to ensure that it goes toward one cause specifically.

There is really no right or wrong here, just personal preference. We often recommend to our new car buying customers that they opt for a lease because if they decide to purchase the car, they can wait until the end of the lease term to make that decision. It’s often a good way to “test” the car out before committing to it long term. Buying the vehicle at the end of the term is also a great way to avoid having to pay over mileage fees if you are not staying on track with your monthly mileage allotment.

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A big benefit to a loan versus a lease is flexibility. With a lease, if you want to terminate your lease early, it can be very difficult (though far from impossible) to do. Companies like Swapalease.com specialize in helping customers walk away from their vehicle lease early without paying huge penalties. (For complete information on terminating a lease early, see "Exiting a Lease Early.")

But even this option is not as easy as having a loan. Let us discuss why: Both a Loan and a Lease have certain restrictions on early termination that you must be aware of.

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A leasing company must create a binding contract with a customer because they are agreeing to buy the car from the dealer for a specific price. The only reason they are willing to buy this car on your behalf is because you have agreed to rent it from them at a premium price. It is a different way for a bank to earn interest on their capital, which is how they make money.

The problem a bank has is that not all customers are able to continue making payments through the term of the lease, which creates a lease default.

Banks worry about lease defaults because they own the car, which means they now have to assume a loss on the vehicle because it is no longer earning interest payments on the lease. Therefore, the bank will make every effort to ensure you continue to make your payments as promised!

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A Loan does not necessarily have a penalty imposed by a bank; however there is another penalty that you must be aware of. When taking on a loan often the depreciation of the vehicle occurs faster than you pay off your principal. For example, when you first drive your car off the lot, it can easily depreciate as much as 10% just because it is no longer considered "new".

Because of this, you are considered "upside down" in your loan. This means that the value of the car is less than what you owe on your vehicle. In many cases it may take 1 - 2 years before you become "right side up" in your loan where you own more equity in the vehicle than it is worth. This is a common misconception about loans.

As mentioned earlier, a loan is also compounded with the problem that most of the interest payments are charged up front, leaving you with very little equity in the vehicle that your monthly payments are contributing toward. So even though you have no contractual liability, you are now saddled with a vehicle that you cannot sell elsewhere or trade-in without taking a huge loss.

If you are considering a loan for the purposes of “exiting early” at any point, you must take into serious consideration these factors. While you certainly have the flexibility contractually, if you cannot actually get out of your loan without paying thousands of dollars in negative equity, there really is not a huge benefit.

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Let’s take a quick look at the similarities and differences between taking on a loan versus a lease. You’ll notice that they are more similar than different:

What you need to consider in making your choice is the longevity of the commitment and the likelihood that you are going to have a need for this particular vehicle at the end of the lease. A lot can change in 3-5 years, so you need to make sure you are comfortable with this type of decision.

There are a number of benefits to leasing as well as taking on a loan. Below is a simple view of the similarities, differences, and points that are surprisingly the same.

These Qualities are the SAME for both a Loan and Lease

• Will depreciate (lose value) at the same rate
• Interest rate will be approximately the same
• The selling price of the car is the same
• Warranty will expire at the same time
• Insurance is required for both

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