How Does Leasing A Car Work?
You’ve probably heard about the benefits of leasing a car. You get to drive a new car every two or three years, enjoy the latest gadgets, and have a much lower payment than if you bought the car, but how do you know if leasing is the right choice?
Does does leasing a car work, anyway? Before you make a decision about buying or leasing your next car, it’s important to understand how leasing works as well as the potential drawbacks to this option.
Lease agreements come with plenty of fine print and hefty fees if you don’t follow your contract to the letter, so here’s what you should know before you step foot in a dealership.
How Does Leasing A Car Work?
In the most basic of terms, leasing works a bit like renting a car except for a much longer period of time and with additional fees. Leasing is a popular option over buying because it allows you to drive a new car with a lower monthly payment than if you bought the car.
A car lease is basically financing for the use of a car instead of the purchase of a car. This use will include the cost of depreciation (or how much value the vehicle loses while you drive it), excessive mileage, and excessive wear and tear.
While a purchase loan means you will eventually pay off the principle balance and own the vehicle outright, lease payments only go toward the use of the vehicle and any finances charges.
You won’t ever own the car (unless you take advantage of the option to purchase at the end of your lease), but your payments will likely be much lower compared to a purchase loan.
The cost of leasing a vehicle is largely determined by depreciation, or the difference between the value of the car at the start of the lease (the MSRP value) and the value of the car at the end of the lease term (the residual value).
Different models and makes have different depreciation rates. This means vehicles with low depreciation are more affordable to lease because you will pay less depreciation.
There are also two types of car leases: closed-end and open-end. Most leases today are closed-end or walk-away leases which allow you to return the car at the end of the lease with no other charges except possible mileage or damage charges. Open-end leases are mostly used for commercial vehicle leases.
Lease contracts can be very complicated and filled with jargon. To help you better understand and compare leases, here’s an explanation of common car lease terms in plain English.
Are There Advantages To Leasing A Vehicle?
Leasing isn’t ideal for everyone, but it can offer several benefits:
- Lower monthly payments. The biggest draw of leasing for many is lower monthly payments. You can drive a new car with a lower payment because you will only be paying for the portion of the vehicle’s value that you use (the depreciation rate) as well as finance charges.
- No down payment. With a lease, you can drive away with a car without a down payment, although some promotional leases do require a down payment. You will still need to pay for the first month’s lease payment and registration and tag fees upfront.
- Reduced maintenance. When you lease a new car, you will likely be driving the car only while it’s still covered by the manufacturer’s warranty. This means any necessary repairs will likely be covered.
- Drive a new vehicle. A lease offers the opportunity to drive a new vehicle every 2-4 years with lower payments.
- GAP coverage is included. Most leases include free gap coverage. This insurance coverage pays off the vehicle if it’s stolen or damaged in an accident.
Not sure if buying or leasing a car is the right move?
Why Should I Think Twice About A Lease?
Despite the benefits, there are definite drawbacks to a lease that you should be aware of before you make a decision.
- No ownership equity. A lease agreement means lower monthly payments, but that means you aren’t building any trade-in value or ownership in the vehicle. The good news is the market value of the car at the end of the lease may be higher than the purchase option price specified in the contract. In this case, you may have value you can use in a trade or purchase.
- High early termination fee. If you want to terminate the lease early, you can expect very high fees.
- Excellent credit may be required. A higher credit score is typically required for a lease compared to a car loan.
- High fees for excessive mileage and/or wear and tear. If you exceed your lease’s mileage allowance, you will be charged per mile at a specified rate that may be around $0.20 per mile. If you go too far over the allowed mileage, this rate can be even higher. Fees also apply if the vehicle has excessive wear and tear like accident damage that is not repaired or scratches. You will be charged for this damage because it reduces the value of the vehicle.
What Happens At The End Of A Car Lease?
When your car lease is up, you generally have five options available:
- “Walk-away,” which means returning the car and walking away without owing anything else except possible damage and mileage fees.
- Buy the vehicle for the specified residual or buyout value listed in your lease.
- Extend the lease term, usually with the same monthly lease payment, for a short period of time such as a few months.
- Re-lease the vehicle which can result in a lower payment, lower residual, and reduced depreciation because the vehicle is now used with a lower value.
- Trade in the vehicle for a new lease. This may allow you to make money if the vehicle’s value is higher than the purchase price in your lease.
If you like the car and it still fits your needs, buying it at the end of the lease may be a good option. First, make sure you do your research. Take the car to a few used car dealerships and ask them to make an offer in cash, not a trade-in offer.
If the amount dealerships are willing to pay is more than your lease says you can pay for the car, it’s a good deal to pick the buy-out option.
If the residual value is higher than the vehicle’s actual value, you can try to negotiate a lower amount at or close to the market value. After all, the leasing company knows they will lose money on it if they get it back so they are likely to work with you.
If the residual value at lease-end is lower than the market value, you have another option: selling the car while it’s under lease.
This can pay off if the vehicle is in demand in the market and you’ve stayed under the mileage limit, but make sure you’re really getting a good deal because you will need to pay the early lease termination fee and disposition fees to take advantage of this option.
Here’s an article explaining how to cash out your lease.
What Happens If I Wreck A Leased Car?
A car accident can be frightening, but wrecking a leased vehicle introduces a new worry: will you be responsible for paying for the car?
If your lease agreement included gap insurance, it will cover the difference between the insurance payout for the fair market value of the car and the amount you owe under your lease.
Many leasing companies require gap insurance so there’s a good chance you have this protection, but not all do. You can also buy gap insurance yourself when you purchase insurance coverage for the car.
If you do not have gap insurance and the car is totaled, you will be in a difficult position: the insurance company will only pay the leasing company the fair market value of the car.
You may still owe hundreds or thousands to make up the difference between this payout and your responsibility under the lease agreement. The newer the lease and vehicle, the higher the gap due to depreciation.
What Are Common Leasing Mistakes I Can Avoid?
Lease contracts can be long, tedious, and filled with confusing terminology. It’s easy to make a mistake that can cost you big if you aren’t careful when you lease a car. If you decide to lease, make sure you avoid mistakes that can cost you thousands.
Paying A High Upfront Cost
When you see amazingly low advertised lease rates, there are usually terms attached. In most cases, these great deals require putting down thousands at signing.
While prepaying your lease isn’t necessarily a bad thing, it will be a problem if your car is stolen or wrecked early in the lease.
In this case, the insurance company reimburses the leasing agency for the vehicle’s value but the thousands you paid upfront are unlikely to be refunded and you will be left without a car.
Not Getting Gap Insurance
Many leases include gap insurance, but don’t make any assumptions. As soon as a new car is driven off the lot, its value drops dramatically. This is true of any new car, including leased vehicles.
If your car is wrecked or stolen, the insurance company will only pay the value of the car which will likely not cover your total lease obligation. This forces you to pay the remaining balance out of pocket unless you get gap coverage.
Not Watching For Low Mileage Limits
See a great advertised lease payment? Read the fine print. In addition to requiring thousands upfront, some leasing contracts instead come with very low mileage limits.
You may have a low lease payment now, but a limit of 15,000 miles a year will hurt if you exceed the limit and get charged $0.10 to $0.30 per mile at lease-end. That’s around $300 for every 1,000 miles you exceed your mileage limit.
Paying A Disposal Or Turn-in Fee
It’s not uncommon for car leases to include a nasty surprise: the disposal fee. This fee is an extra charge you need to pay for the privilege of returning the car at the end of the lease and it can be up to $350.
There are ways around the turn-in fee, such as signing up for a new lease or negotiating the turn-in fee out of your contract before you sign.
Turning In A Vehicle With Damage
Related: Did I Get A Good Lease Deal?
There’s nothing you can do if you go over your mileage limit, but don’t make the mistake of returning a lease with excessive wear and tear.
Every leasing company has its own standards that you will want to understand before the pre-return inspection.
Some leasing companies consider problems like small scratches, minor dings, and stone chips in the finish to be normal wear and tear but damaged fabric, low tire tread, broken parts, and dented trim are typically considered excessive.
Before returning your leased car, shop around and get the repairs done yourself. You’ll end up paying less than the dealership’s cost and some items may still be under warranty.
Leasing a car can be a great choice if you love driving a new car, have good credit, and want a lower monthly payment. Make sure you avoid the potential pitfalls of leasing and read your contract thoroughly before signing.
Before your lease is up, explore your options carefully to make sure you’re getting the best deal and not leaving money on the table.
Do you have any questions about leasing a car or helpful information from a leasing experience? Please leave a comment below!