One way many drivers acquire a new vehicle is through a lease. Leases have benefits and drawbacks that car shoppers should understand before committing to a deal. So what is a car lease, and how exactly does a car lease work?
A lease is like a long-term rental agreement but with a few key differences. You agree to take possession of a vehicle in exchange for a monthly payment over the term of the lease. At the end of the term, you can either return the vehicle to the lease provider and lease a new car or pay out the residual amount (more on that in a moment) to purchase the vehicle outright.
There are several lease types, including:
- Closed-end lease
- Open-end lease
- Single-pay lease
The vast majority of leases offered in today's market are closed-end leases, so for the sake of simplicity, we'll focus on those.
A closed-end lease allows the lessee to walk away at the end of the term.[1] With this type of lease, you have the option to buy the vehicle at an amount that will be predetermined, also known as the residual. Other common leasing terms include:
Gross Capitalized Cost
This is the agreed value of the vehicle at the beginning of the lease. The equivalent in a car loan contract is the principal.
Gross Capitalized Cost Reduction
You can think of this as a downpayment. It's any cash or trade-in value you apply against the lease agreement which reduces your monthly depreciation cost.
Depreciation
This is the difference between the gross capitalized cost (usually the price of the car) and the residual amount.
Monthly Payment
Like a loan, you will pay a monthly payment. In a lease, the monthly payment is determined by the depreciation amount detailed above and the money factor.
Money Factor
The Money Factor is a way leasing companies express the full costs of leasing the vehicle. It accounts for depreciation, interest rate and taxes.
Mileage Cap
Because a lease is more like a rental, there will be conditions on your vehicle use, the most common of which is the mileage cap. This cap ensures that your vehicle depreciates as expected by the leasing company. If you go over it, you may be charged fees at the end of your lease period or pay a higher residual. You can sometimes negotiate your mileage cap.
Residual
Sometimes called a "balloon" payment, the residual is the agreed value of your vehicle at the end of the lease. You can choose to pay this amount and keep the vehicle at the end of your lease term.
Lease Term
This is the amount of time you’ll agree to lease the vehicle — usually 36 or 48 months. Of course, you'll also pay interest on the value, as you are effectively borrowing money to underwrite the lease.
Reasons To Consider A Lease
There are several potential benefits of leasing.
Lower Monthly Payments
It may be more affordable to lease rather than finance a vehicle. This is because you will pay for the estimated depreciation while using the car, whereas a loan covers the entire purchase price. As such, monthly leasing payments tend to be lower than loan payments.
You Could Pay Less Sales Tax
Another benefit is you only pay tax on the portion of the vehicle you use. So if the car is returned at lease end, no sales tax is charged for the option portion. On a retail deal you pay tax on the entire purchase.
You Won't Need To Sell Your Car
When the lease is up, if you’ve met the requirements of the contract, you can walk away. You won't need to worry about selling the vehicle, negotiating a trade-in value, or fretting about how much it's now worth.
Regular Upgrades
Most of the time, you can roll your lease into a new car every three to four years. That means you can look forward to the latest technical gadgets and advanced safety features as you upgrade every time you swap for a new vehicle.
Less Risk Of Unexpected Repair Costs
The short term of most leases means your vehicle will still benefit from the original car warranty throughout, and you may even get a free maintenance agreement from some manufacturers.
You Can Still Buy the Car
At the end of the lease, you still have the option to buy the vehicle from the leasing company. You may benefit if the leasing company had underestimated how much the vehicle might be worth at the end of its lease. For example, if your agreed residual is $10,000, but you know your vehicle is worth $15,000, it might be better to buy out the residual and keep your car.
Potential Drawbacks Of A Lease
While there are some benefits, it's also essential to consider the potential downsides.
You Don't Have Any Equity
You don't own the vehicle and will not be building up any equity. You're only paying for the depreciation plus interest and won't have anything to show for your payments in tangible terms at the end of the lease.
Exceeding The Mileage Cap
You must be very careful to ensure you don't exceed your mileage cap at the end of the lease. If you tend to drive long distances, you may be priced out of the leasing market. Some leases are available with a higher yearly cap but usually have a higher depreciation rate and monthly payment.
Wear and Tear Charges Add Up
You'll be responsible for all damage and repairs to the vehicle over and above expected wear and tear. The leasing company will carefully inspect the vehicle at the end of the contract with the option to add penalties.
It Can Be Expensive To End The Lease Early
While most leasing companies have provisions for early terminations, there is usually a fee attached, and it can be more complicated and more expensive than paying out a car loan early. [2]
Key Considerations When Shopping For A Lease
How should you prepare before shopping for a new leased vehicle?
Assess Your Vehicle Needs and Driving Habits
How you use your vehicle and how often you use it are important considerations for anyone who wants to lease a vehicle. If you live in a remote area with poor roads, drive long distances, or use your vehicle for work and cause a lot of damage to it, then a lease might not be the right option for you.
Assess Your Credit Score
A higher credit score may qualify you for a lower interest rate and, therefore, a lower monthly payment. The leasing company will assess the money factor it wants to apply to your lease agreement using factors like your credit score and the market rate for interest.
How Much Can You Pay Upfront?
Just as with a regular loan, you can lower your monthly costs by paying a certain amount upfront. Leasing companies call this a "gross capitalized cost reduction".[1] For example, if you buy a $30,000 car with a $12,000 residual but put down $3,600 upfront, you will reduce your depreciation amount by $100 a month.
Other Fees and Charges
Most leasing companies add licensing fees and plate registration into the gross capitalized cost, but not all do. You may need to pay these on-road costs before you drive off the lot.
Other Factors To Consider
There are other elements to consider, including the payment terms. Is there any delinquency penalty for a late payment, or does the leasing company offer you a monthly grace period?
Check the small print to see if the company reserves the right to charge fees at the end of the lease and, if so, what for. This is particularly important with wear and tear, so you'll need to see how the company defines that element.
Finally, are there any penalties for early lease termination, and what is the excess mileage charge? Consider the following:
Brand Selection
Be selective when choosing a vehicle to lease, as some brands or models retain value better than others. You can do your research to compare prospective models against each other using used vehicle valuation guides online. Remember that when a leased vehicle retains more of its value, you can expect a lower monthly payment.
Gap Insurance
You may also need to consider gap insurance. Many leasing companies will insist that you carry insurance if someone steals the vehicle or the insurance company declares it a total loss following an accident. If this happens early in the lease, you may pay more to settle out the lease than the vehicle's actual value at that time. Gap insurance will pay the difference for you.
Hidden Fees
Look closely at the fees. You may need to pay an acquisition fee to set up the contract at the outset, which may cover documentation costs, license plates, and car registration. You may also need to pay drive-off fees, including sales tax and other costs put forward by the lessor.
Vehicle Modifications
Ask the lessor whether you can modify the vehicle while under contract. Some companies may allow you to fit any factory accessories but may not allow you to add third-party or aftermarket parts. Also, you may be able to tint your windows, so long as you’re always compliant with the laws in your state.
What Happens At The End Of The Lease?
When the lease is up, you can return the car to the dealership, settle your account, and walk away. Remember, you may have to account for excess mileage or damage greater than any expected wear and tear. Alternatively, you may want to buy the car with cash or a lease buyout loan (if it's available).
There is a third option which involves a lease extension. You may be able to negotiate this on a month-by-month basis or for a fixed number of months instead. Sometimes you may have to sign another contract or just continue making your current monthly payment.
Is A Car Lease Right For You?
A lease can often make perfect sense when you're looking for a vehicle. However, remember that you do not technically own the car during the contract period and will certainly need to consider your mileage allowance.
Conversely, you may be free to drive a new car every three years and take advantage of manufacturer warranties and service arrangements. You may also be able to get more vehicle for your money, as payments for a lease tend to be lower than financing a purchase.
As with any financial decision, conduct research, understand your options and make the decision that best meets your needs.
Learn more about vehicle finance options and calculate your monthly payments here.
