Last week I wrote about how to save boatloads of money buying the car of your dreams — but only after it is two or three years old. This week I want to talk about how leasing a car really works and offer some tips to save you more money on your next car.
OK, so what exactly is a lease? A lease is an agreement you enter into to rent your car for a predetermined length of time (usually 24 to 36 months) for a predetermined monthly payment, and for a set number of miles. These payments are always less than the payment would be had you bought the same car on the same day. The lower payment makes the car look more affordable on the surface, but inside that lease agreement are all kinds of terms that can cost you far more than just the payments.
To start with, why is the payment less expensive with a lease than with a loan for the same car? When you lease, you’re only paying for the estimated depreciation during the length of the lease rather than the entire loan balance you would pay back during that same time frame.
For example, you borrow $25,000 and sign a 36-month loan agreement at 5 percent, giving you a payment of $749, which is a pretty hefty car payment by today’s standards.
For many people, that’s simply too rich for their blood. But if you could swing that payment for those 36 months, you now have a free-and-clear car with a lot of life left in it and, if you were disciplined, you would continue to make that big payment — but instead of giving it to the bank, you could put it into a tax-free account. (More on that next week in Part 3.)
In contrast, when you sign a lease on that same car for 36 months, your payment might only be $300, which is much easier on your pocketbook. But after three years, you still have a balance to pay off if you want to own the car. This balance is called the residual value, and it must be paid off either with cash or a new loan. Most people won’t have the cash to pay off the car, so if they want to own it they have to take on another loan for several more years to actually get the car paid off.
Most people do neither of these things and instead turn in their car and get the next newest model, taking on yet another lease payment — and on and on until they’re old and gray.
In essence, a lease allows you to extend your payments on a car for six to eight years, and you end up shelling out far more in payments and interest (yes, there’s a hidden interest rate with a lease) for the same car. Sure, you have a lower monthly payment, but you have many more payments in total, sucking even more money out of your bank account.
So instead of just winging it, what if you actually employ a strategy for your next car?
If you can’t afford the three-year payment, then how about committing to no more than a five-year note? Can’t afford that either? Then the truth is you really can’t afford that car. Shop for something less expensive, perhaps a model year or two older, and buy that instead.
Then once you pay off your car, you should make a commitment not to buy another one for two years. That way you can continue to make your monthly payment — but to yourself — into a tax-free account.
According to IHS Automotive, the average length of time people hang on to a car is nearly six years, so you’ll go one extra year for good reason.
It will look like this in real numbers: You borrow $25,000 at 5 percent for five years on your next car, resulting in approximately a $470 monthly payment, which you pay for five years. Then you own the car free and clear. But then what will you do with the payment you were making? If you’re like most people, you’ll blow it on junk.
But you — you are not like most people. You have a plan.
Instead of adding to your junk collection, you could instead continue making that payment from your checking account every month — but now the money goes to a bank (or a pool of money) that you control. If you do this for the next 24 months, you’ll accumulate $11,280, plus the growth on that money (guaranteed and tax-free if you do it right), which would put you at a total of about $13,000 you’ve saved for yourself and your family.
That $13,000 in a tax-free account that gets just 5 percent compound interest will be worth more than $35,000 for you in 20 years. Could you do that on every car you and your spouse ever own? If you do, you’ll have hundreds of thousands dollars more for your family in the years to come.
According to the Employee Benefit Research Institute, the average American only has $56,000 in savings by the time he’s 65 years old. But by mastering this car strategy, you could have four or five times that amount over your lifetime, depending on when you start.
Now some of you are wondering why you still need to make a payment to yourself every month instead of just letting the unused money sit in your checking account. That’s simple: Human nature won’t allow you to truly “save” your car payments unless you get the money out of your day-to-day cash flow and easy access. Money is only truly saved if it’s focused — and not frittered away on other things we really don’t want or need.
Focused cash flow is the key to wealth, and the disposition and growth of that cash flow is critical if you want to get ahead and have more options later in life.
Have you ever “saved” money on a big-ticket item in your life? Where are those savings now? Precisely! Get in the habit of taking your “savings” and truly making them savings by getting them out of your cash flow account and into a separate tax-free account.
In today’s world, automobile ownership is a luxurious necessity. Sure, it’s nice to own a nice car, but over time the costs of doing so are enormous. You need a strategy to stop the wealth drains of depreciation and interest.