Leasing an automobile is an alternative to purchasing that usually enables consumers to pay lower up-front costs and make affordable monthly payments. At the end of the lease period, however, the consumer does not own the vehicle. Instead, consumers opting for automobile leasing arrangements pay for the use and depreciation of the vehicle over the duration of the lease. Purchasing a vehicle for cash is usually the most cost-effective option, followed by financing a purchase and, finally, leasing. The best option depends to a large extent on the individual consumer's situation. In many cases, leasing enables people to drive a more expensive car or to pay a lower amount per month than they would under a purchase arrangement. Leasing can be an attractive option for small business owners because of the tax deductibility of lease payments on cars used for business purposes. In recent years, many special lease deals have been established with small business owners in mind.
BUY OR LEASE?
The decision of whether to buy or lease an automobile depends upon a number of factors. First, it depends upon how long the consumer tends to keep cars before obtaining new ones. Leasing tends to make more sense when the consumer changes cars at least every four years, because then monthly car payments are a basic part of his or her budget. Second, the buy-or-lease decision depends upon the amount of annual mileage the consumer tends to put on cars. Leasing is less attractive for people who regularly drive long distances, since most leases impose mileage limits (generally 12,000-15,000 miles annually) and charge a high fee for excess mileage. However, many car dealers allow consumers to purchase extra miles at a reduced rate at the time the lease is signed. Finally, the decision depends upon the consumer's budget. Leasing is a good way for people on a limited budget to minimize up-front costs, since they are usually required to pay a down payment consisting only of the first month's lease rate plus a security deposit.
It is also important to note, however, that there can be hidden costs associated with leasing. For example, many dealers charge a variety of lease-end fees. A disposition fee of several hundred dollars is common for consumers who do not wish to purchase the car. In addition, dealers often levy "excessive wear and tear" charges against customers when they turn in their vehicle (typical charges are for significant paint scratches, large windshield cracks and chips, upholstery and carpet burns, mismatched or bald tires, etc.). According to Business Week, dealers dun customers for such charges on nearly 30 percent of leased vehicles, charging an average of $1,600 per vehicle. In addition, some dealers establish maintenance rules for leased vehicles and charge fees when consumers fail to perform the required maintenance. In some cases, there are higher liability insurance requirements for leased vehicles than for those acquired through a purchase arrangement, which also costs consumers more money. Finally, most dealers include a premature termination clause in the lease contract and charge consumers a disposition fee, the car's residual value, and the remaining lease payments to end the lease early.
HOW AUTOMOBILE LEASES WORK
Like financed purchases, automobile leases require consumers to make monthly payments. Rather than covering the principal and interest on a loan, however, these payments cover the use and depreciation of the car over the lease period. The amount of the payment is calculated using the purchase price (capitalized cost) of the vehicle, its expected residual value (cost less expected depreciation) at the end of the lease, a fraction of the going interest rate (called the leasing factor), and applicable taxes. In some lease agreements an additional fee is included to cover all regular maintenance requirements.
The first step in calculating the monthly payment is to determine the monthly lease rate. This rate is equal to the capitalized cost, plus the residual value, multiplied by the leasing factor. The next step is to find the monthly cost of depreciation on the vehicle by subtracting the residual value from the capitalized cost, then dividing by the number of months in the lease.
A closed-end lease—the most common kind—means that the dealer assumes the risk that the car's residual value will be lower than expected at the end of the lease period. In this type of lease, the consumer can either buy the car for the residual value or walk away. In contrast, an open-end lease means that the consumer assumes the risk that the residual value will be lower than expected, and must make up the difference if this is the case. In exchange for accepting greater risk, the consumer usually makes lower payments in this type of lease. In general, two- or three-year leases tend to be the most cost-effective for consumers. Shorter leases do not justify the added taxes, while longer leases mean that the car will require too many repairs.
TAX BENEFITS OF LEASING
Leasing rather than buying an automobile often holds some tax benefits for small businesses. "Leasing may beat buying when it comes to tax benefits," Donald J. Korn wrote in Black Enterprise. "Under current law, the interest you pay on a car loan is usually not deductible. However, when you lease, the finance charges are included in the monthly payment. If you get to deduct three-quarters of your lease payment, you're actually deducting three-quarters of the interest as well."
Small business owners can deduct a percentage of their automobile lease payments—as well as fuel, maintenance, and insurance costs—from their federal income taxes. To calculate the deduction on a leased vehicle, a small business owner would use the actual-expense approach. This approach adds up all the costs of operating the car for a year and multiplies that total by the percentage of the annual mileage that was attributable to business purposes. It is necessary to maintain an accurate mileage log and associated automobile expenses in order to support the deduction.
The mileage deduction is a better deal for self-employed people than for those who work for companies. Self-employed persons merely report the leasing expense with their other business expenses. Employees, on the other hand, must report leasing expenses with other miscellaneous itemized deductions; the deduction is only allowed for the amount by which the expense exceeds 2 percent of their adjusted gross income. It is also important to note that commuting to and from work is considered personal rather than business mileage for employees.
SEE ALSO Equipment Leasing
Coulombe, Charles A. "Little Fleet: A New Approach to Leasing Lets Small Businesses Zoom into High Gear." Success. October 1997.
Edgerton, Jerry. Car Shopping Made Easy. Warner Brothers, 2001.
Fisherman, Stephen. Deduct It. Nolo Press, 2004.
"Leases: Dings to Watch." Business Week. 24 April 2000.
Sykes, Tanisha Ann. "Is Car Leasing for You?" Black Enterprise. April 2000.
Hillstrom, Northern Lights
updated by Magee, ECDI