Home General How Car Leasing Works

How Car Leasing Works

  • How a car lease works
  • When to lease a car instead of purchasing it
  • Car lease advantages
  • Car lease disadvantages
  • What to look for in a car lease
  • Who owns the car in a lease?
  • What happens at the end of a car lease

Leasing now accounts for nearly one in three new-vehicle transactions, but aside from the attraction of lower monthly payments, what do you really know about leasing a vehicle? Is it something to consider when shopping for a new car? Could it make a significant difference in your monthly budget? Here’s how a car lease works, why it can work to your advantage, and how to avoid common pitfalls that could end up costing you money.

How a lease works

Leasing, in essence, is like a long-term vehicle rental over a set period of time. The cost you pay is largely dictated by the vehicle’s depreciation (loss of value) while it is in your possession. You also pay to cover the financing of the transaction. This results in monthly payments generally lower (often much lower) than those for the purchase of that same vehicle. That’s why so many carmakers today advertise special lease deals.

The monthly payments are attention-getting to traditional buyers.  But while buying a car may look more expensive because of the higher monthly payment, keep in mind because you are purchasing the “whole car” not just getting the use of that car over a set period of time the total of the monthly payments results in you owning the car.  That car’s value will likely be many thousands of dollars.  At the end of a lease you end up with nothing but memories of the vehicle you once had.

When to lease a car instead of buying it

Several factors can make leasing a car more attractive than buying one. The more important one is how many miles you drive in a year. If it’s less than 15,000, then leasing might be for you. That’s because a car’s resale value is largely dictated by the amount of mileage. Say you drive about 12,000 miles a year and after a 2- or 3-year lease, your vehicle has 24,000 to 36,000 miles. It will be worth more than a vehicle driven 20,000 miles a year with 40,000 to 60,000 miles on it. The higher the resale value, the lower your calculated monthly payments.

Another reason to consider leasing is if you decide that you have allotted a car payment as part of your permanent monthly budget. If that’s your fixed transportation expense, you may find that putting that money towards a lease will keep you in a newer car. The lower monthlies of a lease versus an outright purchase also mean you’ll likely be able to drive a more expensive car for the same payment.

Car lease advantages

As the average transaction price (ATP) of vehicles continues to climb leasing is being used as a way to keep monthly car payments in check. Automakers are increasingly relying on lease deals as a way to package incentives and rebates so that they don’t affect the Manufacturer’s Suggested Retail Price (MSRP), which has remained largely untouchable during a model year. With the proper research, you may find that a lease is in fact more generous than cash-back or subsidized interest rate deals on a purchase.

With higher vehicle prices, more and more buyers are facing replacement purchases that result in longer loans in order to keep the monthly payment at about the same level. The average length of loans has been stretching from the standard 36-, 48- and 60-month terms to as long as 84 months. This also means you could be going from 5 to 7 years between new cars. If you like the idea of driving a newer car, leasing is a viable alternative since contracts tend to range from two to four years in length.

Convenience is another factor. Since you don’t have an equity stake in the car, you don’t have to worry about trade-in or going through the hassle of selling your car to a private party.  Leasing a car also means that the car is covered by the manufacturer’s warranty and in some cases the deal may also include regularly scheduled maintenance, so you have almost no repair liability. A really long term loan could end up costing you for extended warranty coverage as well as routine and unscheduled maintenance and repairs to get comparable peace of mind.

Car lease disadvantages

While leasing has many advantages, there are pitfalls. If you accumulate a lot of miles in a year, then leasing may not be for you. It would be more economical to buy the car or finance it over a longer period. The typical leases have caps ranging from 12,000 to 15,000 miles per year. Exceed the cap and you may be on the hook for excess mileage charges that could end up costing you thousands.

In addition to the mileage caps, leases also have provisions making the lessee responsible for excess wear and tear. While scratches and dings are inevitable when considering a lease find out what constitutes normal wear and tear and what you may or may not be liable for and for how much.

When you sign a lease, you are committing to the entire length of the lease and are responsible for all the payments. If you want to get out of the deal before it’s time to turn in the car, you may find yourself liable for early termination charges, which could amount to the full value of the remaining payments. Again, check the contract carefully to fully understand the extent of your liability.

What to look for in a car lease

While the monthly payment may look affordable, be sure to take into account any upfront money required to sign the deal. A $2,400 down payment on a 2-year lease is the same as adding $100 to your monthly payment. Other things to consider are additional fees like acquisition and disposal fees that may add $500 to $1,000 to your total cost. These payments should be factored into what your equivalent monthly payment or be a point to be negotiated away when closing the deal.

According to Experian, the average monthly car payment is about $550, while an average lease payment is $100 less. A rule of thumb is that a monthly payment of $100 to $150 per month per $10,000 of a car’s value is a good deal. Kelley Blue Book data puts the Average Transaction Price of new vehicles at around $35,000. So for an average midsize car or compact SUV, expect a monthly lease payment of $350 to $525.

Who owns the car in a lease?

To the manufacturer, a lease is just like a sale but not to the person who ends up driving the vehicle. Typically the vehicle is sold to a financial institution backing the lease. You, as the lessee, are not the owner of the vehicle; instead, the lessor holds the title. Even though you don’t hold title for the vehicle, you are responsible for its use, which includes registration and insurance.

The latter is important because if you are in an accident and the vehicle is a total loss, you are responsible for the car’s replacement. If the value exceeds your coverage, you may be liable for the difference (or the balance of the lease payments). As a result, it may be wise to consider extra-cost GAP (Guaranteed Asset Protection) insurance to provide coverage in such an event.

Factors that determine your payment

Three basic components comprise the lease structure: vehicle acquisition cost (which may or may not be based on the car’s actual MSRP), the cost of money financing the transaction, and the vehicle’s projected resale value at lease end.

Capitalized cost is the basic building block of the lease. It’s important to ask and understand this value. It greatly impacts your lease payment and whether or not you’re getting a good deal. On hot-selling models, the capitalized cost incorporates the vehicle acquisition price, which could be at MSRP or above depending on market demand. On slow-selling cars that are eligible for factory incentives, the price may be less than MSRP and in fact in some cases, could be at dealer invoice or below, depending on the program.

Finance charges are based on the cost of money and applied to the capitalized cost over the life of the lease, much like monthly finance charges.

Also affecting that value is any upfront payment, which lowers the capitalized cost.  Another big factor is the residual value — what the lending institution expects the vehicle to be worth at the end of the lease. If the vehicle performs well on the used car market, the residual will be high. This translates into a lower capitalized cost and lower lease payment. If the vehicle has a low residual value, the capitalized costs and monthly payment will be higher. Be sure to check the resale value of the particular model you’re looking to lease to see if it aligns with the projection in the lease document.

What happens at the end of a car lease

There are two types of leases, open- and closed-end contracts. A closed-end lease is also referred to as a walk-away lease. Once you’ve finished the lease term, you turn in the car and barring any excess mileage or wear-and-tear issues, you simply walk away. It is up to the lessor, who has assumed the risk of the vehicle’s resale value to handle its disposal. If the value is higher than the residual value, the lessor pockets the difference; if it’s less than the estimated residual the lessor is out the money. Since the lessor assumes the resale risk, closed-end leases cost more than open-end leases.

In an open-end lease, you share the risk. If the vehicle is worth more, you may get a refund. If the vehicle is worth less, you may owe the lessor money. In some cases, the residuals are intentionally set high to reduce the capitalized cost and in turn, the monthly payment. But this can result in a so-called balloon payment owed by the lessee at the end of the term. Understanding the relationship between the vehicle’s residual value and your responsibility to pay is critical. This will avoid any nasty surprises when you return the car. Be certain you know which type of lease you are acquiring before you sign the documents.

In any lease, you should also determine whether or not you have an option to buy the car at the end of the contract and at what cost. That ability pays dividends if used car values are up and you can buy the car you are familiar with at below-market pricing.

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