With the average new vehicle costing around $36,000, consumers are leasing cars and trucks at a record pace to help keep their payments affordable. Leases now account for around 30 percent of all new car or truck transactions.
If you’re considering trading in your current vehicle and leasing a new one, you may be tempted to make as large a down payment as possible on it, as one might do when buying and financing a car. Here’s why that may not be a good idea.
For starters, know that leasing a car is not the same as buying and financing one. A lease is essentially an extended rental that usually runs from 24 to 39 months. Monthly payments are based primarily on the difference between a vehicle’s transaction price (including taxes and fees) and what it’s expected to be worth at the end of the lease contract, which is called its residual value. That amount, minus any down payment, is financed at a set interest rate, which is also called the money factor in leasing lingo.
When the lease is up, you can either simply return the vehicle to the dealer or leasing company, or purchase it at a predetermined price. If the predicted residual value ends up being less than what the vehicle is actually worth at the end of the term, you can earn some cash by purchasing the car and selling it to another party at a profit.
While leasing guarantees you’ll be making perpetual car payments, they’re lower than with conventional financing. On the downside, leases come with strict mileage limits. Exceed them, and per-mile penalties will add up quickly. Likewise, you’ll be charged an excess-wear-and-tear fee if you return the vehicle in sub-par shape. You’ll likely also face an acquisition fee of a few hundred dollars up front, and a disposition fee at the end of the term.
Working the Numbers
All else being equal, making a larger down payment will result in lower monthly lease payments. The down payment usually consists of the first month’s installment and a capitalized cost reduction that decreases the amount being financed. This is usually referred to in automakers’ ads as cash due at signing. If you have good credit, you will usually be able to lease a car with zero cash paid upfront, but your payments will be higher.
Here’s an example of how a down payment affects leasing terms: We found two advertised lease deals for the same $25,000 vehicle. Not including taxes and fees, one was at $199 a month for 36 months with $2,999 due at signing. The second was quoted at $289 a month with zero down. Choosing the zero-down deal keeps that $2,999 in your pocket. Still, this deal costs an additional $90 a month.
Should You Use Your Car’s Trade-in Value as a Down Payment?
If you’re cash-strapped and are trading in an older car that’s only worth a couple thousand dollars, it might make sense to use the proceeds as a down payment to keep your lease payments affordable. On the other hand, you may not want to do this if your trade-in is worth considerably more.
If you’re financing a new vehicle, making a bigger down payment increases your equity in it. This helps to ensure you won’t wind up owing more money than the vehicle is worth. If the vehicle’s book value is less than you owe on the car loan and the vehicle is stolen or totaled, you’ll owe the bank the difference between what the insurance company will give you and the outstanding loan balance.
By contrast, a down payment on a lease is merely an advance payment on the deal. Many leases have gap insurance built into the contract. If the vehicle is stolen or totaled, this insurance pays the difference between its book value and the amount owed on the lease. You will not, however, get back your down payment.
Some would suggest it’s best not to make a down payment at all. Paying a large amount of cash up front on a lease tends to defeat its advantage as a money-saver. You may be able to come out ahead by instead investing the amount, or using it to settle other debt. Plus, in many states, you’ll have to pay sales tax on the amount due at signing. You’ll have to pay tax on the deal regardless, but avoiding the down payment means you’ll spread it evenly across your monthly installments.
Many personal finance websites have calculators that will determine monthly lease payments based on the size of your down payment, the purchase price, number of payments, sales tax rate, current interest rate and the vehicle’s expected residual value. As you run the numbers, be sure to determine your total long-term costs by multiplying the monthly payment by the number of installments and adding the down payment, if any, along with other applicable expenses.
Editor’s note: This article was originally published in January 2015. It has been completely updated for accuracy and comprehensiveness.