Kelley Blue Book’s Complete Guide to Leasing

By KBB Editors on June 8, 2016 12:00 PM

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 a short primer on leasing, why it can work to your advantage and how to avoid common pitfalls that could end up costing you money.

Leasing, in essence, is a 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 plus, of course, some dollars to cover the financing of the transaction, and therein lies its primary appeal. The monthly payments are 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 those of us who are used to buying our cars.  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.

Lease Advantages

So why is leasing so popular?  Because when you pay and how much you pay are both important to you and your monthly budget. Leasing could be seen as making your car dollar go farther.  As the average transaction price (ATP) of vehicles continues to climb (KBB estimates that ATP now exceeds $33,000) 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 Manufacturers 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.

Because of the lower monthly payments, you also may be able to take advantage of leases that allow you to opt for a higher-line vehicle with more features than you could acquire through an outright purchase. Again, due to the fact you are only acquiring use of the vehicle for a contracted period of time – basically buying “part” of the vehicle’s useful life – your monthly lease payment will be far lower than the monthly payment to purchase of the same model, and the difference could be hundreds more per month.

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 three 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 for two to three years 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.

Leasing may also be advantageous if you have a relatively short commute or travel fewer than 12,000 miles per year. Fewer miles mean a higher resale value at the end, and if you opt to purchase your car at the end of the lease period, you’ll know exactly what you’re getting in a low-mileage used vehicle, because it’s been in your possession.

What to watch for

While leasing has many advantages, there are pitfalls to avoid. 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, for some reason, 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.

Also, beware of acquisition charges or upfront payments to get into the lease. Some deals may not ask for a down payment, but if there is do some quick math to determine how much that is actually adding to your monthly payment. A $2,400 down payment on a 2-year lease is the equivalent of adding $100 to your monthly payment. Additionally, an upfront payment to acquire a lease is not like a down payment on a purchase because it does not give you equity in the vehicle.  Although not a common as upfront payments, some lease contracts may include a disposal or disposition fee when you return the car. Again, that payment should be factored into what your equivalent monthly payment or be a point to be negotiated away when closing the deal.

How a lease works

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 title is held by the lessor. 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 totaled, 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.

While a lease differs from an outright purchase in many ways, because it is a financial transaction interest rates do impact your lease payment. There are three basic components to the lease itself—the vehicle’s acquisition cost (which may or may not be based on the car’s actual MSRP), the cost of money that is used to finance the transaction, and the vehicle’s projected residual value at the end of the lease period.

Capitalized cost is the basic building block of the lease, and it’s important to ask and understand this value, for it has a profound impact on 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 for the vehicle. On slower 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 the program. Also affecting that value is any upfront payment, which lowers that figure as well.  Another major factor is the residual value -- what the lending institution expects the vehicle to be worth at the end of the lease. If the vehicle is expected to perform 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. The 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.

Closed- vs. Open-End Leases

Residual values also play an important role on the basic terms of the lease, which you should fully understand before entering the contract. 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 and it is up to the lessor to handle the vehicle disposal. The lessor has assumed the risk associated with the vehicle’s resale. 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 is assuming the resale risk, closed-end leases tend to cost more than open-end leases.

In an open-end lease, you share the risk. If the vehicle is worth more, you may be entitled to a refund. If the vehicle is worth less, you may owe the lessor money. In some cases, the residuals are intentionally set high in order to reduce 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 to avoiding any nasty surprises when you return the car. These days the closed-end lease is the norm, but 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 could pay dividends if used car values are up and you have the opportunity to buy a car you are familiar with at below-market pricing.

If you typical buy a vehicle with conventional financing every two or three years, you are a good lease candidate. If you are comfortable holding your cars longer, it might make more sense to buy.  But while leasing is a more complicated transaction than a straight-up purchase, a little patience, research and knowledge can make the difference between getting a good or a great deal.