How Does Leasing a Car Work?

Car dealer showing new car to young couple in showroom
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Leasing a car is an alternative to buying one. You're essentially borrowing a car for an agreed-upon period instead of buying it outright. Sometimes you may have the option to purchase the vehicle after the lease ends.

If you're considering leasing a car, it's important to understand how it works, as well as its advantages and disadvantages

What is a Car Lease?

A lease is a contract in which one party conveys the use of something (a parcel of land, building, service, or another object) to another party for a specified period of time in exchange for payment of money, typically on a periodic basis.

In a car lease, the object being conveyed is the vehicle itself. The difference between leasing and financing is that with financing you are purchasing the vehicle to own, and with a lease you usually don't own the vehicle. Unless your contract has the option to purchase the car at the end of the contract period, you must turn it back over to the lessor.

Image shows a man looking at three cars in a parking lot and he is tapping his chin looking pensive. Text reads:
Image by Bailey Mariner © The Balance 2019

Leasing Advantages and Disadvantages

Drivers who prefer to lease instead of buy tend to do so for a couple of major reasons. First, they get to drive a newer vehicle that remains under warranty throughout the lease period and, therefore, rarely requires anything more than routine maintenance.

Second, monthly payments for a leased vehicle are normally smaller than those for a purchased vehicle. That's because lease payments are based on the depreciation in value of the vehicle over the course of the lease period instead of the vehicle's full value. As a result, drivers can lease a vehicle that is nicer and more expensive than one they could afford to purchase.

There are disadvantages to leases, too. One is that over the course of a lessee's lifetime, they will likely end up spending more on their vehicles than a buyer. Another disadvantage is that at the end of the lease period, the lessee must turn in the leased vehicle (or buy it through a purchase option agreement) and walk away without any equity in the vehicle.

So, which option is best? That depends on the driver's unique needs and preferences.

The Lease Process and Terms

Cost is always the bottom line, and when it comes to figuring the cost of a car lease, it can get a little complicated. That's why it's important to have a good basic understanding of the terms used in the lease agreement. When you sit down with the dealer to go through the lease process, here are the most common terms you will have to deal with:

Manufacturer's Suggested Retail Price (MSRP)

This is the full price of the new vehicle, also known as the sticker price. Except for the rare case when a specific model is in high demand, you should be able to negotiate the MSRP down, sometimes significantly, because it's only a suggested price.

Capitalized Cost (Cap Cost)

This is the base price that you hopefully negotiated down to from the MSRP. The cap cost can also be referred to at this point as the "lease price."

It's a good strategy not to let the dealer know that you intend to lease the vehicle until you have determined this cost. And if your dealer tells you that you cannot negotiate the MSRP down if you plan to lease, don't believe it. The cap cost, as well as just about every other figure in the lease process, is always negotiable.

Residual Value

This is the wholesale value of the vehicle at the end of the lease term. Lessors estimate the residual value at the time the lease is written based on historical resale value data.

Depreciation

Depreciation is the difference between the value of the vehicle when it is new and its residual value. Put another way; it is the decrease in the value of the vehicle during the lease period. The depreciation cost is what makes up the biggest part of the lease's monthly payment amount.

A great way for you to get an idea of what all of your leasing costs will be beforehand is to use a lease calculator available at one of several websites such as edmunds.com and bankrate.com. And don't forget: All costs and most terms are negotiable. 

Money Factor or Lease Rate

This is just the interest rate stated differently. Remember, when you lease, what actually happens is that the leasing agency is purchasing the vehicle from the dealer and then leasing it out to you. The money factor is used to determine the second biggest part of your monthly lease payment and represents the amount of money the lessor is charging you for tying up its capital during the lease period. The money factor, like other interest rates, depends heavily on the lessee's credit score.

Mileage Allowance and Charges

Part of all car leases is a stated maximum number of miles that the lessee can drive the vehicle per year, known as the mileage allowance. The standard mileage allowance for a private driver lease normally ranges from 10,000 to 15,000 miles per year. If a driver exceeds the mileage allowance, they'll be charged an additional fee per mile. All figures here can be negotiated by the parties.

Lease Term

This is the length of the lease. Typical leases are two, three or four years long, although they may be shorter or longer. Lease terms are typically stated in terms of total months (24, 36 or 48, for example).

Purchase Option Agreement

This is an option to purchase the vehicle at the end of the lease period. This option is normally taken at the beginning of the lease and will add a small amount to the monthly payment. The sales price is also written into the lease upfront and is often the same as the residual value.

Upfront Fees and Charges

If you decide to lease your car, be prepared to make a substantial upfront payment consisting of several fees and charges such as a down payment, taxes and license fees, acquisition fee, security deposit and others. As with car financing, a higher upfront payment may mean lower monthly payments.

Penalties and Additional Charges

These include default charges (for late payments), early termination fees ( for ending the lease before the agreed-to period), disposal fees (when the lessee opts to not purchase the vehicle at the end of the lease period), and wear-and-tear charges. Wear-and-tear charges are those made to cover wear and tear on the leased vehicle that goes beyond what could be considered normal or reasonable. In some cases there are ways to break a lease without a penalty. 

Article Sources

  1. Consumer Financial Protection Bureau. "What Should I Know About the Differences Between Leasing and Buying a Vehicle?" Accessed April 12, 2020.

  2. Merriam-Webster. "Lease." Accessed April 12, 2020.

  3. AARP. "To Buy or Not To Buy." Accessed April 12, 2020.

  4. Consumer Financial Protection Bureau. "What is a Manufacturer Suggested Retail Price (MSRP)?" Accessed April 12, 2020.

  5. LeaseGuide.com. "Capitalized Cost – Cap Cost." Accessed April 12, 2020.

  6. Autotrader. "Leasing a Car: Can You Negotiate the Price?" Accessed April 12, 2020.

  7. Edmunds. "The 'Residual Value' of Leasing." Accessed April 12, 2020.

  8. Federal Reserve. "Keys to Vehicle Leasing: Future Value." Accessed April 12, 2020.

  9. LeaseGuide.com. "Money Factor—Explained." Accessed April 12, 2020.

  10. Federal Trade Commission. "Financing or Leasing a Car." April 12, 2020.

  11. Federal Reserve. "Keys to Vehicle Leasing: End-of-Lease Costs: Closed-End Leases." Accessed April 12, 2020.