Car leases and car loans are simply two different methods of automobile financing. A car lease finances the use of a vehicle; a car loan finances the purchase of a vehicle. Each has its own benefits and drawbacks.
With a car loan, you pay for the entire cost of a vehicle, regardless of how many miles you drive it. You typically make a down payment, pay sales taxes in cash or roll them into your car loan, and pay an interest rate determined by your loan company. You make your first payment a month after you sign your contract.
With a car lease, you pay for only a portion of the vehicle’s cost, which is the part that you “use up” during the time you’re driving it. You have the option of not making a down payment, you pay sales tax only on your monthly payments (in most states), and pay a money factor that is similar to the interest rate on a loan. With car leases, you may also pay extra fees and possibly a security deposit that you don’t pay when you buy. You make your first payment at the time you sign your contract.
Buy vs. lease example
As an example, if you lease a car that costs $25,000, that will have an estimated value of $15,000 after 24 months, you pay for the $10,000 difference (this is called depreciation), plus finance charges, plus fees. When you buy, you pay the entire $25,000, plus finance charges, plus fees. This is fundamentally why a car lease has significantly lower monthly payments than a car loan.
Car lease payments are made up of two parts: a depreciation charge and a finance charge. The depreciation part of each monthly payment compensates the leasing company for the portion of the vehicle’s value that is lost during your lease. The finance part is interest on the money the lease company has tied up in the car while you’re driving it. In effect, you are borrowing the money that the lease company used to buy the car from the dealer. You repay part of that money in monthly payments, and repay the remainder when you either buy or return the vehicle at the end of the car lease.
Car loan payments also have two parts: a principal charge and a finance charge, similar to lease payments. The principal pays off the vehicle purchase price, while the finance charge is loan interest.
However, since all vehicles depreciate in value by the same amount regardless of whether they are leased or purchased, part of the principal charge of each car loan payment can be considered as a depreciation charge, just like with a car lease – its money you never get back, even if you sell the vehicle in the future.
The remainder of each car loan principal payment goes toward equity. It’s what remains of your car’s original value at the end of the car loan after depreciation has taken its toll. Equity is resale value. It’s what you get back if you sell the vehicle. The longer you own and drive a vehicle, the less equity you have.
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