- In our very first episode, we recommended buying a used car with cash as the most financially sensible option.

- But for many people, that's just not possible.

The majority of Americans finance their vehicles with loans, and with rising prices and rising interest rates car loans are getting more expensive than ever.

- [Julia] The average interest rate on a new car jumped from 4.4% to 7% in just the last year.

The amount that Americans now owe on cars has doubled since 2011, making up over 9% of total US consumer debt.

- You think that this might be a good time to forego buying and lease a car instead?

No debt, no commitment, and lower monthly payments than a car loan.

- They can seem attractive at first, but lease agreements have plenty of financial pitfalls, and are just as vulnerable to price and interest rate hikes as buying.

- They're not always a bad idea.

Ultimately, it depends on what matters to you, and how much you're willing to pay for it.

(jaunty music) - The fundamental misconception about car leases is that they work like other rental agreements, like for apartments or furniture.

They don't.

Cars are a unique asset for one ugly reason.

Depreciation: nothing costs so much yet loses value so fast as a car, except maybe timeshares or bitcoins, and lease agreements are designed to account for that.

- Here's how it works.

If you wanted to lease a new car for the typical term of 36 months, the dealer will take the selling price of the vehicle and subtract what it's predicted to be worth in three years, known as the residual.

The result is essentially the depreciation, how much value the car will lose while it's in your possession, which you are required to pay off in monthly installments.

But here's the kicker.

That amount is treated like a debt.

Just like a car loan, you'll pay interest and fees determined by your credit score, and often be required to put up a down payment.

- In this way, a car lease is less of a rental, and more like buying the most expensive years of a car's life.

And because they depreciate so quickly, that can be close to half its total value.

True, it's less than the sticker price.

So your monthly payments are lower than a car loan would be for an equivalent vehicle, but when the lease is up, you have no asset to show for it.

- Some lease agreements allow you to buy the car at the end of the term at its residual price, but because leases tend to have higher fees than car loans, you'll end up paying more than if you had just bought it outright to begin with.

- Another supposed advantage of leasing a car is the freedom it affords for those who are scared of commitment.

It can seem exciting to swap vehicles every few years, but leasing comes with its own set of restrictions.

- First of all, most lease agreements have a mileage limit for the term of the lease, usually between 12,000 and 15,000 miles per year.

And if you go over that, you'll pay extra at a rate as high as 50 cents per mile.

You can opt for a higher mileage limit, for a higher monthly payment of course, and you will not be reimbursed for any miles you didn't use.

- Second, you must return the vehicle exactly how you received it.

So don't bother upgrading the stereo, or installing custom rims, unless you don't mind reinstalling the old ones before you bring it back.

- And lastly, lease agreements are notoriously hard to get out of.

Early termination incurs penalties that are sometimes as much as the total remaining balance all at once.

And unlike car owners, you can't just sell the vehicle if you don't want it anymore.

You're pretty much stuck with it until the term is over.

- To be fair, there are some advantages to leasing a car.

Many lease agreements include routine maintenance costs, and newer cars are typically still under a manufacturer's warranty.

That's no small thing, considering car repairs are one of the most common unexpected financial crises people have to deal with.

You'll never have to go through the hassle of selling it.

And if you own a small business, leasing a car can offer big tax benefits.

Unlike car loans, in which you can only deduct the interest, lease payments by businesses are fully tax deductible - But the main appeal of leasing is largely psychological: having access to a nice, new, reliable car that you otherwise wouldn't be able to afford.

The benefits of comfort, status, and safety may not be financial, but that doesn't mean they're worthless.

What's the point of money if it can't make us happy?

- But are they worth enough to overcome the cost?

- I think it's time to- (together) run the numbers.

(triumphant music) - [Julia] Michael and Ali are both in the market for a car, and each has room in their budget for around five to 600 bucks a month, with the same good credit score.

Ali decides to buy a used car for $20,000.

He puts $3,000 down, and ends up with 36 monthly payments of about 540 bucks.

- [Phillip] Michael wants something fancier, so he decides to lease a new car with a selling price of $40,000, which will lose about 40% of its value over the three year term.

He also puts down $3,000, and including interest and fees, he'll end up paying about $580 a month for 36 months.

- [Julia] At the end of three years, both men have paid roughly the same amount of money, but their financial situation couldn't be more different.

Ali now owns his car free and clear, and he can sell it for probably half to two thirds of what he paid for it, or he can drive it until it falls apart, which could be five to 10 years from now, depending on how well he caress for it.

- [Phillip] Michael, on the other hand, is right back where he started.

Instead of buying out the residual for $24,000, he opts to lease another new car under the same terms.

If we fast forward another three years, Michael will have paid about $25,000 more than Ali.

After a total of nine years, even if Ali has had to shell out $10,000 in maintenance and repairs, he'll still be almost $40,000 ahead of Michael.

- Now, Michael isn't paying that money for nothing.

He gets to tool around town and a brand new ride with all the amenities.

Whether that's worth it depends on what matters to you.

But generally speaking, if you can't afford to buy a new car, you probably can't afford to drop $40,000 on a luxury, either.

- At the end of the day, inflation and rising interest rates haven't changed the math on leasing.

- If you have a car in working order, take good care of it, and drive it for as long as you can.

And if you're in the market for a vehicle, buying, even with a car loan, still makes the most financial sense.

- Leasing provides the short-term benefit of driving a nicer car for lower payments, but you're not solving a problem, just buying time.