Unless you can afford to pay for your next car in cash, you’ll need to make some financial arrangements before you can buy the car. That means you’re signing up for one of two things: financing or leasing. These two methods of paying for cars look similar in that they break your costs up into monthly payments. Below the surface, though, these two financial tools work very differently. Here’s what you need to know when deciding between financing vs leasing a car.
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Go back to Section 4: Where to Buy a Used Car
A glossary of relevant car financing terms
Before we dig in, there are a few important terms to know when learning about automotive financial tools.
Term: The term of a financing or leasing agreement is its length. For example, a lease may have a term of 36 months (3 years), or you may agree to a financing term of 84 months (7 years). This is how long you’ll need to make payments to fulfil your agreement. When all other factors are equal, a shorter term will give you higher monthly payments, but your payment obligation will end sooner. A longer term means you’ll have lower monthly payments, but it will take you longer to reach the end of your agreement.
Principal: In financing, the principal is the amount of money you’re borrowing. For example, if the car you’re buying costs $45,000 including all fees and sales taxes, then the $45,000 you receive from the lender to buy the car at the start of the loan is the principal. As you repay more of the principal throughout your loan term, you get closer to owning the car in full. (In leasing, there is no principal. We’ll explain why in the leasing section below.)
Interest: Interest is the fee you pay to the lender. In automotive finance, an interest rate is usually presented as APR, which stands for annual percentage rate. Interest rates can vary greatly based on a number of factors. A lower interest rate means you’ll pay less to your lender over the loan term, and a higher rate means you’ll pay more. Your goal is always to pay as little interest as possible.
What is financing a car?
When you finance a car, you borrow money to pay for it up front and then repay that money to the lender. Vehicle financing looks much like any other loan you’d arrange with a financial institution, such as a mortgage on a house or a business loan for a startup. Financing is an option when buying new or used vehicles. At the end of the financing period, your loan is paid off and you own the vehicle in full. This means you’ll no longer need to make car payments and the car is yours to use, sell, give to a family member, or otherwise make decisions about however you see fit.
You have several options when shopping for financing. If you’re buying a car at a branded dealership, you may be able to secure financing through that brand’s financial division. While the services aren’t identical, you can think of this as a bank that’s owned by the vehicle manufacturer. You can also apply for an auto loan through a traditional bank or credit union. There are other financial tools you can use to pay for a car (such as an unsecured loan or a line of credit), but bank or automaker car loans are the most common and are almost always the most favourable. It’s worth shopping around and comparing interest rates between these sources before signing a financing agreement to ensure you’re getting the best deal.
How interest rates affect your financing costs
When you’re arranging vehicle financing, you’ll need to decide on a term. Most people choose a longer term to get lower monthly payments. The most common financing term in Canada today is 84 months (7 years). However, it’s important to understand how much a longer term truly costs.
Let’s say we’re financing with a principal of $45,000 at an interest rate of 8 percent. On a 60-month term, your monthly payment would be $912.44, and you would spend $9,746.40 on interest. On an 84-month term, your monthly payment would be $701.38, but you’d spend $13,915.92 on interest. That’s an extra $4,169.52 you’ll need to pay with no additional benefit to you. (We calculated this with the Government of Canada’s Vehicle Lease or Loan Calculator.)
In addition, with the seven-year term, it takes two years longer before you fully own that vehicle. If you need to sell it for any reason — your household needs change, you move overseas, etc. — it’s much easier to do this when the vehicle is yours. If it’s not, you’ll either need to pay the loan off early or sell the car while you still owe money on it, which limits your options.
Plus, if the terms of your warranty don’t align with your financing term — e.g., you have a five-year new vehicle warranty but seven-year financing — you’re stuck paying for that vehicle even if it starts giving you trouble once it’s out of warranty. This could cost you far more money than you’d like.
The best move is to aim for the shortest financing term you can with a monthly payment you can still afford. You may find it’s worth choosing a smaller vehicle or a more affordable trim to help you reduce the length of your term while keeping your payments manageable.
How does a car lease work?
When you lease a car, you’re paying a monthly fee to borrow the car long-term. The most common lease terms are 36 months (3 years) or 48 months (4 years), though shorter or longer terms are possible. At the end of the lease term, you don’t own the vehicle (though you may be offered the chance to purchase it). It’s possible to lease a used car, but this financial tool is more commonly used with new vehicles.
A lease can be a good option for those who prefer to change cars often, but it can also be restrictive. You’ll have a limit on the number of kilometres you can drive the vehicle per year, and you’ll pay a fee at the end of the lease if you exceed that distance. You’ll also need to pay if a vehicle needs repairs or modifications or is showing excess wear and tear when the lease is up. Plus, if you need to get out of the lease early for any reason, you’ll find it’s a very stressful, time-consuming, and expensive process.
How are lease payments calculated?
Lease payments are calculated based on the difference between what the car is worth at the start of the lease and what the lender estimates it will be worth at the end of it. The amount of money between these two figures is known as depreciation, which is the amount of value a car loses over time. All cars depreciate, and they do so at the fastest rate in their first years on the road. Essentially, this means you’re paying for your car’s depreciation costs on your lender’s behalf, plus interest.
The upside to this is, since you’re paying only the depreciation costs and not the vehicle’s full purchase price, your monthly payments will typically be lower. The downside is, at the end of the lease, your money is gone and you have no car to show for it. There is an exception here, though: your lease may include a clause that lets you buy the vehicle once it’s up for a predetermined price. If that price is close to the car’s actual market value, this can be a sound financial decision.
Leasing vs financing a car?
Think of financing versus leasing a car like owning versus renting a home. A variety of factors can determine which is the right decision for you. Here are some points to consider.
Finance if:
You want to put your money toward owning an asset.
Your driving habits aren’t predictable from one year to the next.
You want the freedom to sell your car easily if necessary.
You’re happy to drive the same car for a few years.
You can find a good balance between a reasonable term and an affordable monthly payment.
Lease if:
Building equity in an asset isn’t important to you.
Your driving habits are very stable year after year.
You’re certain your household needs won’t change during the lease term.
You care about having the latest tech and features and love changing cars often.
You need a car, and leasing is the only way to get a monthly payment you can afford.
How to shop for cheap car finance rates
A loan or lease’s interest rate is one of the most important factors that determines how much your car will cost you over time. Securing the lowest interest rate you can find should be one of your primary goals. Here are some tips for finding lower interest rates as you prepare to lease or finance your next vehicle.
Research interest rates before you start shopping
If you go into the process with a baseline expectation, you’ll know when you’ve found a rate that’s better than average. If you still aren’t sure whether to buy a new or used car, be sure to look up the rates for both. Used vehicles typically come with higher interest rates than new, which may affect your decision. (Learn more about choosing between new and used vehicles here.)
Compare the rates offered by different automakers and traditional banks
Different financial institutions may offer significantly different rates. It’s a good idea to check the rates offered by various automaker finance divisions and traditional banks and credit unions. Try using some online rate quote aggregators to quickly dig for better rates across a variety of financial institutions.
Make the largest down payment you can
A lower loan principal can sometimes net you a lower interest rate. You can reduce the principal by offering a cash down payment, trading in your existing vehicle, or a combination of both. If you have the financial flexibility, it’s worth asking your lender whether putting more down up front will get you a better rate.
Choose a shorter term
Interest rates are sometimes lower on shorter terms. Ask your lender to walk you through a variety of terms so you can explore your options.
Monitor Bank of Canada interest rate announcements
All interest rates are determined based on the Bank of Canada’s interest rate. This is updated eight times per year. Be sure you’re aware of any upcoming announcements, and watch the news to learn whether to expect any changes. If experts predict a rate increase is coming up, it’s a good idea to secure a rate ahead of that announcement. If they predict a decrease, waiting until after the announcement may get you a lower interest rate with your lender.
Be diligent about maintaining your credit score
This is a longer-term consideration, but it’s an important one. If you have a good credit score, lenders will trust you more to make your payments on time and will offer you better interest rates. You can check you credit score for free with reporting companies like Equifax or TransUnion. Your bank may also offer this service. Other factors to do with your personal finances, such as your income and your debt-to-income ratio, can also affect the interest rates you’re offered.
Watch for incentives
How does 0% financing work? Automakers will sometimes offer very low or zero-percent interest rates to people buying certain vehicles who have great credit scores. If you’re deciding between a few vehicles and one is offered with a very low or 0 percent interest rate, choosing that vehicle could save you a lot of money.
Continue to Section 6: Understanding Car Insurance
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