Lease buy out? An exercise in Epistemic problem framing.

I have an important financial decision to make soon, and I thought I would run it by the Beards & Money readers to make sure I'm not thinking stupid. The best way to avoid costly money mistakes is to convince others why before you buy. Basically, I need to figure out whether or not I should exercise the lease buy out for our fancy newer car.

Right now, the Beard family has two cars. A nearly new 2013 sedan with 22,000 miles and an older 2006 station wagony SUV-like sorta thing with 70,000 miles. The newer car is leased with the term expiring in September. The residual is $12,500. The older car is owned outright and is worth about $6,000 on the private market.

We have decided that we are going to become a one-car family, and we have to decide which car needs to go. At first, it seemed easy. Turn in the leased car to the dealer in September and that's that.

But, I'm on a roll with writing about this whole money expert thing. I've written about how the smart folks look at money issues from all kinds of directions, instead of getting stuck on one framing of the situation.

Ty at Get Rich Quick'ish recently discussed one practical application of expanding your problem framings when he questioned the bromide that paying off debt should be job number one.

It's my turn to give you a glimpse of my Ivory Tower secret decoder ring, and show you an honest-to-goodness problem that needs solving. My problem. And how I'm trying to think like a money expert by thinking about all the possible ways to frame the problem.

Should I buy out the lease for $12,500 and sell the older car, or just turn in the leased car and rock the paid-for older car?

What is a lease, anyway?

In the world of auto-finance idiocy, a lease is typically a way for money dumbasses to get a car they can't afford for a monthly payment they might be able to afford. Usually, they're pretty bad deals. Dave Ramsey spends epic hours of air time bitching about them. However, leases are not always dumb.

Here is basically how a lease for a car works:

First, you negotiate a price. Let's say you get the dealership to sell you a new car for $20,000. The price of the car is what is called the capitalized cost, or sometimes the shorter "cap cost."

If you have some cash to make a down payment, then you can apply that to the lease in what is called a capitalized cost reduction. In our example, we're going to assume a "sign-and-drive" lease, where you plunk down not a single cent. (I'll ignore fees and taxes, too, for simplicity. Just assume they're rolled into the $20k capitalized cost.)

The lease finance company sets a residual valuefor the vehicle your leasing. This is a guess about what the car will be worth at the end of the lease term. The average car loses 15% of its valueper year. For a 3-year term, that leaves a residual value of $12,300 for our $20k car.

Basically, with a lease you are financing the difference between the capitalized cost and the residual value minus any capitalized cost reduction. You are renting the car from the finance company and paying for the depreciation.

It's like a loan (only not technically a loan) in the following amount:

Financed Amount = Cap Cost - Cap Cost Reduction - Residual Value

For our example, you would be financing $7,700 over three years.

The finance company will charge you interest on that $7.7k, of course. Now, they could call this something simple that you can understand, like, I don't know ... maybe interest. That's too easy and not confusing enough, so for a lease this interest is called the money factor.

The money factor is represented as a number such as ".0008". This can be converted to an interest rate by multiplying by 2,400. A money factor of .0008 equals an annual interest rate of 1.92%. They do this because it's stupid, confuses you, makes you feel dumb, and as part of the whole "wearing you down" aspect of buying a car that gets you to part with more of your money.

For our example, let's assume a financed amount of $7,700 over three years with an interest rate of 1.92%. You're monthly payment would be $220 per month. Not bad for a brand new car.

If you had bought the car outright with a similar interest rate and the same 3-year term for payoff, then the monthly payment would be $572! If you stretched the term over 4 years, you'd pay $433. If you got one of those re-friggin-diculous 6 year car loans, then you're monthly payment would be $294.

Do you see why some people lease? Brand new car for a much smaller monthly payment. And if you're in the mindset of always having a monthly payment and swapping out for a new ride every few years, then a lease is not a bad way to do it.

What is a lease buy out?

A lease buy out is when you buy the car at the end of the lease term instead of giving it back to the dealer.

In the lease contract, you typically have the option of buying the car at the end of the term for the agreed upon residual value. In our example, after 3 years you could either turn the car back over to the dealership, or you could buy it outright for $12,300.

If you're in the market for a new car for some reason, then leasing isn't necessarily a bad idea. You get to "try" out the car for a few years, learn exactly how much it depreciates with time, and if everything lines up, you can buy the car outright if you want to. If you don't like the car, turn it in.

Usually, the money factor (or interest, for those of us that like things all non-stupid) is crazy low for new car leases because the finance company IS the car company, and they want to sell cars.

Should you lease a car?

Whether or not you should lease a car is a question you'll have to decide for yourself. There are good and bad reasons to lease.

Why you might want to lease a new car:

You're getting a new car anyway, but you're not sure about that new model. Will its value hold up well compared to other cars? Will it be reliable? Will it be one of those new models that keeps having problems?
You have a job that requires a lot of driving and wear-and-tear on a vehicle. You need something that's always under warranty (your job depends on reliability) and is always nearly new.
Your job provides a monthly vehicle allowance, or a reimbursement on a vehicle payment and miles.
You need a nice ride to use for your ride-sharing business (you're an Uber driver), but you might be out of business in 2-3 years for other reasons, and/or you wouldn't otherwise roll a fancy ride.

Why you shouldn't lease a new car:

To get lower payments for a car you can't really afford. I like Sam Dogan's 1/10th of annual income rule for buying a car.
To justify having a new car when you don't really need one. After all, the finance payments are as low as the payments for a nice used car.
You plan to drive your car until it dies and the thought of buying another car in two to three years makes you cringe.
You're rich, bitch! You can drop $20k cash without a hiccup. (Though, you might still lease because they're basically giving you free money with interest rates these days.)
After your done paying for years, you usually have zero equity in the car. (I'll get to how you might have equity in a bit.)

My guess is that most of the Beards & Money readers shouldn't lease a brand new car. Most of the readers of this blog are getting their fiscal shit in order, and dropping significant change on a depreciating asset is a losing proposition.

And those readers are right!

Why I have a leased car

I have a leased car because we wanted a new car. We didn't need a new car. We wanted a new car.

For years, we had old, nearly busted paid for vehicles. We had a minivan for a while that had a transmission go out. It had minor electrical problems. It needed a new fuel pump. And other things ...

I'm handy and minivans have engine compartments you can climb in, so I did pretty much all of the work on the van myself (except the transmission!) The repair costs were not ridiculous (except that damn transmission).

The problem with the van wasn't really the time I spent fixing it. That was basically fun for me. Like a hobby.

The problem was it always broke at completely inopportune times. It wasn't reliable for my wife. She has car-hypochondria, so any little shimmy causes her great anxiety.

We got a new car for my wife's peace of mind. Brand new, full warranty, if it has problems take it to the dealer who fixes it for free.

This is poor reasoning, because that van had zero problems for the first 5 years we owned it. We could have just bought another nearly new used minivan (or small car like we leased) for $8,000, rocked it for 5 trouble-free years, and then sold it for $3,000.

Those 5 years of ownership would have cost about $5,000 plus any small maintenance. With our lease, we financed about $7,000 of depreciation over 3 years. The used-car route was obviously the better fiscal deal by the numbers.

Or was it?

Lease buy out and our specific deal

Here were the terms of our lease:

First, we got a great deal on the price. We "bought" the car at the end of the year right when the new year models were coming out and they were trying to get rid of current year models. The car we bought was a Kia, and Kia was just starting to make a big impact on the US market. The retail price was $25,000.

Would the Kia be a piece of shit? Who knew at the time? This is why we leased instead of buying outright. Three months later and Kias are as everywhere as Hyundais. Apparently they became very popular.

The Kia has a fantastic warranty, too. The service department for the local dealer has been really good with fair, upfront pricing for non-warranty items. The only issues we've had are that they use shitty batteries and fairly crappy tires. Otherwise, the car has been completely hassle free.

My wife loves it. It doesn't cause her an ounce of anxiety. Not a bad deal for $150 per month.

We have a low money factor, too, because I have stellar credit and Kia really, really wanted to sell new cars in the US market.

I have come to realize that the pay outright for a used car route would have been the smarter money play, but I'm not upset about the deal we did make. In fact, the used car route might NOT have been the smarter play in the end.

The reason: residual value.

The Kia's depreciation has run at a rate significantly slower than average and as anticipated by the finance company that holds our lease. Right now, near the end of our 3-year term, the Kia we are borrowing has a private-party value of $14,500.

We could sell this car to a private party right now for $14,500. A dealer would have it on the lot for $16,500 - $18,500. This explains why we've been getting a lot of calls from our local dealer and the Kia finance company about what we plan on doing in September.

They've offered to let us out of the lease early, incentives on new vehicles if we do, and other goodies. Why?

Because we have the legal right to buy the car for $12,300 in September. We have the legal right to pay $12,300 for a vehicle we can turn around and sell for $14,500 on the private market, and the dealer could turn and sell for even more.

They want that car back to earn more profit, and they're hoping I'm too stupid to understand the lease terms, or that I haven't paid any attention to the car's true value.

Unfortunately for them, their constant calls and emails actually tipped me off. Why did it seem they were desperate to get me out of my lease?

We almost went through with an early lease termination because we left for Europe in January and haven't driven the car since. We'd only have a couple months of driving it left when we got back, and we knew we wanted to drop to one car anyway.

But when the finance company calls you, then there is a reason. So I started trying to frame our little problem in a few different ways. What if we kept the car? What would that take? How would it compare to just turning it in? Is the older SUV-like thing the best deal for us right now?

Sometimes you do have equity in a lease

We have $2,200 in "equity" in our Kia right now. We could execute the lease buy out, and turn around and sell the car on the private market, pocketing $2,200.

It's a little more complicated than that, since we'd need to avoid paying sales tax twice, but the Googles has us covered on that end. I won't get into the details here, since it's not the point. But we can make money off the lease by executing our option to buy.

So that $7,000 cost over 3 years just became about $5,000. That's awfully close to the 5-year cost of owning a used vehicle. It's still not quite as good "by the numbers," but keep in mind we've got a full warranty on the new car and absolute piece of mind. That has value, too.

I should also point out that we basically got lucky. The only reason we have equity is because the Kia held value better than average and the finance company didn't know it would do that. On cars with a historical tendency to depreciate slower, the residual value is typically set properly.

If it was three years ago right now, armed with the fiscal discipline we're displaying today, then we would never had leased a brand new car. I guarantee you I would have made a very different decision. Hell, we probably would have kept the minivan, since the biggest expenses had already been paid and we would have had another 3 - 5 years of life on the thing without much major issue.

But we did lease the car. It happened. The question is: what do we do now?

Should we keep the Kia or the other car?

The decision to go to one car is made. Now we have to decide to either buy the Kia and sell the older car, or keep the older car and turn in the Kia.

Obviously, if we actually decide to let the Kia go, we'll try to sell it on the private market for the profit.

In one scenario, I add about $2,000 to my bottom line.

In the other, I have to spend money.

Seems easy, right? Well, let's frame the problem a little differently. Instead of thinking of the problem as a "how much cash do I put in my pocket" problem, let's frame it as a "which increases my net worth more" problem.

Right now, my net worth calculation has $6,000 built in for the asset value of my older car. I don't include the value of the Kia because I don't own it. So if I keep "Old and Busted," then its value stays in the net worth, plus I add the profit from the lease to my bottom line for a net change in net worth of $2,000.

If I sell "Old and Busted" for $6,000, then I need to come up with $6,300 in cash to buy "New Hotness." Since the Kia is worth more than I can buy it for and more than the older car, then my net worth actually goes up by $8,200.

Framed as a net worth problem, it looks like keeping the Kia is the way to go.

There is another way to look at the problem, though.

Let's assume we own neither car right now. Which would we buy if we were on the used car market? And, would we choose something else completely?

Would we spend $6,000 for a 2006 SUV-like thing with 70,000 miles?

Or would we spend $12,300 for a 2013 small car with 22,000 miles?

Neither is necessarily a bad deal. First, our annual income should be a hair over $120k this year, so both cars fit within the 1/10th annual income rule of thumb.

The Kia is more expensive, but it's a newer car with less miles and two years of full factory warranty, and 7 more years of power-train warranty. The 2006 is 10 years old, but it is very low mileage, which might suggest it was well taken care of. No warranty at all, so if the transmission blows up we're out of luck.

The Kia is a small car with great fuel efficiency. The SUV-like 2006 is a gas hog and is big. We ultimately want a smaller car, so the Kia seems to win in that battle.

We're also in a good position for a decision because we know something about both cars that you usually don't know in most car transactions: history.

The Kia has been completely trouble free and has demonstrated a history of above average depreciation.

The SUV-like thing has already demonstrated problems and is at a mileage range were stuff like tie-rod ends and fuel pumps start getting replaced. It's also demonstrated a below-average depreciation.

If I had to choose between the two cars at the true market prices, then I would go with the Kia.

That's two framings that seem to point to the Kia as the winner, and one framing that points to the older car.

Triangulation is starting to tell me that the Kia lease buy out is probably the better deal overall for my family.

What about getting rid of both and buying another car?

There is one more framing I want to explore. I could sell the older car, exercise the lease buy out and sell the Kia, and then buy another car altogether.

What kind of car do my wife and I ultimately want? We want a smaller (though not compact), fuel efficient car. It needs to fit three in the back seat, with one of the seats occupied by a car seat. That's hard to do in a Honda Fit or a Mazda 3. So, we're ultimately looking for a mid-size sedan.

Basically, we want something like the Kia. If we're looking in the 2013 year range with low mileage, then it makes no sense to buy something else, since we can get the Kia for significantly below market.

That leaves mid-sized sedans in the 2010 year range for a little less. But those don't come with two years of factory warranty (piece of mind for the wife) and would be a complete mystery in terms of history. We know everything that's been done with the Kia, because we're the only ones that have ever owned it.

It looks like I'm deciding to exercise the lease buy out, sell the older car, and rock the Kia from now on.

Framing problems in multiple ways is what a money expert does

Go back and read my post about how experts solve problems. The biggest distinction between an expert problem solver and a novice is that experts frame problems in multiple ways and triangulate towards a solution. Novices get fixed in one framing.

In this particular problem, I have used a couple of different epistemological resources:

Analytical calculation
History resource
Knowledge as propagated stuff (1/10th rule)

I have also framed the problem in several ways:

Cash-in-pocket framing
Net worth framing
Current needs framing

I've probably missed a few ways of looking at the problem, but I've drawn upon my experience to look at the problem in as many ways as I know how.

After approaching the problem from many directions, I have used the process of triangulation to come up with a solution. Many of my framings start pointing to the same answer, so that's probably the best answer.

Notice that I'm not trying to solve the problem of lease vs. buy, or new vs. used. Those problems were already solved in the past, and possibly not optimally with the information we had at the time.

So ... did I leave something out of my analysis? Is there another way of looking at our little problem that I missed? Am I being stupid to buy the Kia? You tell me in the comments. Because if I haven't convinced you, then maybe I need to come up with better reasons or start looking at the problem again.