How to Finance an Auto Purchase

How to pay for a car is probably more challenging and confusing than choosing a car. You will encounter many jargons which you do not understand and many calculation formulas that you are not familiar with.

The following chart illustrates the options you will have. First, you have to decide whether to buy or to lease the car. If you want to buy the car, then you are facing another tow options: buy it with cash or loan. Lease is another option that many people take, but you also have to make decision on the types of leases and payment options.

Lease vs. Buy

Lease Buy
Terms A lease is usually between 2 to 4 years. A loan contract is usually between 4 to 6 years.
Ownership The leasing company has ownership. The user own the vehicle if it is purchased with cash. If it is purchased with a loan, the financial institute holds the title until the loan is paid off.
Equity No equity is built up. Equity is built up.
Up-front Cost It includes the first month's payment, security deposit, a capitalized cost reduction, taxes, registration fees and other charges. It is usually less than the up-front cost of a loan. It includes down payment, taxes, registration fees, and other charges. It is usually more than the up-front cost of a lease.
Insurance The insurance premium is usually higher. The insurance premium is usually lower.
Early Termination Lessees are responsible for early termination charges. The user is responsible for paying off the loan.
Maintenance Lessees are responsible for the maintenance of the vehicle during the lease term. The user is responsible for the maintenance of the vehicle.
Mileage Limitation Has mileage limit. No limit.
Wear and Tear The lessee might need to pay for excessive wear and tear at the end of the lease. No wear and tear restriction.
End of Term Return the vehicle or buy the vehicle. The user owns the vehicle.
Tax Tax is paid only on the monthly payment Tax is paid up front on the full price of the vehicle
Cash Flow Less cash is tied up. More cash is tied up than lease.
Down Payment No or low down payment Down payment is required.
Monthly Payment Calculation In a lease, the lessor uses the money factor to calculate the lease fee. Monthly lease payments are calculated based on the depreciation, money factor, tax and other fees. Lease payments are usually lower than loan payments. Annual Percentage Rate (APR) is used in loan calculation. It is equivalent to money factor x 2400.
Monthly loan payments are based on the total amount of purchase price, Annual Percentage Rate, taxes and other fees.
Credit Rating Lease requires better credit rating than loan. Loan requires relatively lower credit rating than lease.
Gap Insurance Many lease agreements include gap insurance. Most loan contracts do not include gap insurance.

Closed-end Lease vs. Open-end Lease

In a closed-end lease, the residual value is pre-determined. At the end of the lease, the lessee just returns the vehicle. The lessee may pay for any extra mileage or damage on the vehicle. With an open-end lease, the residual value is determined at the end of the lease. If it's worth less than the originally-estimated residual value, The lessee pays the difference. If it's worth more, the lessor pays the difference.

Single Payment Lease vs. Periodic Payment Lease

With a single payment lease, the lessee made a lump-sum payment in advance rather than periodic payments made over the term of the periodic payment lease. The amount of single payment should be less than the total amount of periodic payment, but the money is tied up rather than being put to better use elsewhere. Also, with a single payment lease, the lessee will lose all the money that has paid into the lease if the vehicle is stolen or destroyed in an accident.

Cash vs. Loan

Purchasing a car with cash is the least expensive way. It makes the transaction very simple. Financing a car can divert cash to paying off other debts or making other investments.