How Leasing a Car Works

How to lease a car has probably crossed your mind if you’re shopping for a new set of wheels. Financing is a top concern for a lot of buyers, as a vehicle is one of the most expensive one-time purchases you can make.

So before you drive off the lot in your new investment, learn how a car lease works. Our guide will explain the ins and outs of this popular option so you can decide if it’s the right choice for you.

How to Lease a Car: How Is It Different from Buying?

To understand how to lease a new car, you need to know how the process is different from buying one. It’s not at all like renting a car for the weekend when family comes to town.

Instead of a matter of days or weeks, your lease agreement allows you to drive the leased vehicle as you like based on its terms, whether it’s commuting to work and school or simply running errands in town.

Car leasing is actually similar to renting an apartment. You make your monthly payment, and you get to use the leased car for a specific amount of time. This predetermined number of months varies depending on the lease deals you can find out there.

However, it may not be the best fit for some drivers because instead of paying down your loan, your monthly payment covers the car’s estimated depreciation and interest while it’s in your possession. You’re also locked into this agreement until your lease expires, and you don’t get to keep the car when it’s over either (unless you buy out the lease).

Pros of Leasing a Car

Car leasing has become a popular method for acquiring a new vehicle for a variety of good reasons, including:

Lower Monthly Payments

With a lease, you only pay the estimated depreciation while you drive the car. That means that leasing payments tend to be lower than those on a loan.

As a result, your monthly budget will likely go further when leasing a car than when financing one. Affordability is one of the top reasons people decide to lease.

Drive a New Vehicle

If you’re the kind of person who loves that new car smell, leasing may be perfect for you. You’ll get to drive a new car every two or three years.

Access to the Latest Features

Whether you’re into technology or want the latest safety features, leasing a new car ensures you have access to the best features as they hit the market.

Walk Away When It’s Over

You won’t have the hassle of selling your car or trading it in at the end of the lease. Instead, just take it back to the dealership, hand over your keys, and walk away.

Lower Maintenance Costs

The leasing company expects you to follow the maintenance schedule outlined in your owner’s manual carefully. The good news is that many new leased vehicles come with a free maintenance plan, and you’ll have access to the manufacturer’s warranty during the lease period.

Buy for Less

If you still like the car at the end of the lease, you can buy it. If the leasing company underestimated its residual value, you might even be able to cash in and purchase the car for less than it’s worth.

This situation happens most often during a tight economy when suppliers can’t keep up with consumer demand.

Pros of Buying a Car

Buying your next new automobile also comes with a few perks, including:

Sell It Anytime

When you buy a car, its cash value becomes an asset. You can sell it or use it as a down payment if you trade it in for another vehicle.

Free and Clear Ownership

When you buy a car, you can keep it forever. Consider that it will be payment-free after you settle your loan in four to six years, which is another pretty good reason to opt for this approach.

If you continue to lease, you’ll be paying depreciation on your second lease by the time your loan would be paid off — and you’ll still have zero equity.

It’s Easier to Break the Contract

Getting out of a car loan is much easier than breaking your vehicle’s lease agreement. As long as you pay off the balance, that is.

Cons of Leasing a Car

As attractive as leasing a car is for many shoppers, there are a few cons you should consider, like:

Annual Mileage Limits

How much you drive counts when leasing a car, thanks to mileage limits. Many leases cap out at 10,000 miles per year, although 12,000 is becoming more common.

If you do your research, you may be able to secure a lease with up to 15,000 miles. However, expect to pay more, as these plans are usually more expensive.

Nevertheless, it may be better than getting stuck with a mileage penalty at the end of your lease. At around $0.25 per mile, that overage can really add up.

No Equity

With a lease, you’ll never build equity because you won’t own the vehicle when your lease term ends.

What you pay for with a lease is depreciation, and a car loses as much as 40 percent of its value within the first three years. So at the end of your lease, you won’t have anything to show for all those monthly payments.

Damage Costs

Your leasing company will hold you accountable for excess “wear and tear.” This term refers to any damage the inspector decides is beyond their definition of “normal.”

You’ll get a bill for repairs. However, minor scratches smaller than a quarter may not result in extra charges.

Termination Fees

One of the most significant drawbacks of a car lease is an early cancelation. You’ll have to pay hefty penalty fees if you want to get out of your agreement before the lease ends.

You may even find yourself faced with a balloon payment equal to your outstanding amounts on the lease. While it may seem unlikely that you’ll need to turn in your vehicle just a year or two after you sign up with the leasing company, life happens.

Cons of Buying a Car

Buying a car isn’t all roses, though. Here are a few reasons you might avoid buying a car and opt for a lease instead:

Down Payment Requirements

If your credit is less than stellar, your lender may require you to make a substantial down payment on a new car. According to Experian, you may have to hand over up to 20 percent “or $5,000 on a $25,000 purchase ” to improve your odds of getting funded.

Leasing could help you keep some of that up-front cash, so you can make your new car a reality.

Higher Monthly Payment

Purchasing a vehicle typically comes with a higher monthly payment than leasing the same model. The reason for the extra expense is that you’re paying off the entire purchase price of the car, not just depreciation.

Risk of Negative Equity

You may have heard the term being “upside down” on your car loan. That means that depending on the debt’s term, depreciation, and interest calculation, you may owe more than the vehicle is worth before you get the chance to pay it off.

Expired Warranty Coverage

If you opt for an extended loan term of six years or longer, you could end up owning a car with an expired manufacturer’s warranty. You’ll have to pay for all of your repairs out of pocket when that happens. For example, a brand-new transmission could cost you between $4,000 and $7,000.

Understanding the Terminology

Before you sign the lease contract, make sure you understand all the terminology. These are a few key phrases that you need to know:

  • Lessee: You (or the person leasing the car).
  • Lessor: The bank, credit union, or other institution financing the lease.
  • Down payment: This includes your first and last month’s lease payment, plus a security deposit.
  • Term: This represents the number of monthly payments you’ll make, typically between 24 and 48 months.
  • Acquisition fee: These fees cover administrative costs, like pulling your credit report.
  • Drive-off fees: These amounts are due in cash to begin the lease before you “drive off.”
  • Disposition fees: This cost covers expenses to prepare and sell the vehicle when you return it.
  • Money factor: Think of the money factor as your interest rate.
  • Allowable mileage: This figure represents the maximum number of miles you’re allowed to drive the car each year.
  • MSRP: This acronym stands for the “manufacturer’s suggested retail price.”
  • Capitalized cost: Also called the sale price, this is the actual price you pay for the car.
  • Residual value: This amount represents how much the manufacturer will pay you to buy back the car at the end of the lease.
  • Depreciation: The market value your car loses during the lease term.
  • Payoff amount: This is what the car will cost you to buy at the end of the lease, usually the residual amount minus your security deposit.

Types of Leases

Before you commit to leasing a vehicle, you should understand these different types of leases:

Closed-End Leases

Closed-end leases are the most common and come with a set length. For example, if you pick up your car from a local dealership on Nov. 1, 2022, and sign a three-year agreement, it will expire on Nov. 1, 2025.

The advantage of this type of lease is that you’ll know the vehicle’s payoff amount when your contract expires. However, you could pay penalties if you turn in the car early or late.

Open-End Leases

This type of lease is the most flexible because it doesn’t have an exact end date. Instead, the leasing company gives you a window of time to turn in the car penalty-free. This period varies by provider and can even be as long as six months.

The downfall of this lease is that you may have to cover the difference between your car’s estimated value at the beginning of the lease and its actual value at termination.

Subvented Leases

If you have a high credit score, consider a subvented lease. It works much like the traditional closed-ended option. However, the leasing company rewards your excellent rating with a discount.

Leasing incentives could include a break on your money factor, which translates into a lower APR or a rebate on the price of the vehicle. Either way, you’ll be in a terrific position to save money.

Single Payment Leases

With a one-pay lease, you’ll make all of your monthly payments upfront. If you have a large nest egg but a poor credit rating, this strategy could motivate a lender to take a risk on you.

By securing a lease, you can vastly improve your overall score. Another excellent reason to take this route is that you’ll usually pay a lower money factor rate than if you stretch your payments out over several years.

Used Leases

While the practice isn’t as common as leasing a new vehicle, you can lease a used car. Some dealerships and manufacturers even lease pre-owned vehicles that are up to 10 years old.

You’ll still need to get approved, but the credit requirements to lease a used car may be more lax than those strict conditions of a new vehicle lease. Your payment will probably be less as well.

However, you’ll likely have to cover repairs, as most manufacturers don’t extend warranties for more than five years or 60,000 miles.

Short-Term Leases

Not all companies offer short-term leases or those between 12 and 24 months. Yet this does come with some distinct advantages. With this option, you get the freedom to lease a new car every year or two.

It’s also easy to get out of your financial obligation if you’re not ready to commit to a vehicle long term. Just remember that the shorter your contract, the higher your monthly payment will be.

Long-Term Leases

When referring to leasing vehicles, “long term” usually means four years or more. If you plan to lease your car for 60 months or more in an effort to reach an affordable payment, consider buying.

During this extended period, your bumper-to-bumper warranty could expire, and you have a higher chance of going over your agreed-upon mileage limits.

How to Lease a Vehicle in 9 Steps

Every leasing company has its own procedures and criteria for approval. Nevertheless, the application process has a few common elements. You can feel confident following these 10 steps:

1. Check Your Credit Score

To lease a vehicle, you’ll need a credit score of 620, and most dealerships prefer a prime rate of 680 or higher. It may be possible to sneak by with a lower rating if you have a sizable down payment.

There are many ways to improve this essential factor, and the higher your number, the less you’ll have to pay in interest.

2. Set a Budget

You’ll want to calculate how much car you can afford. Remember that in addition to your monthly lease payment, you’ll need cash upfront for your security deposit, sales tax, and acquisition fees. You’ll typically have to pay these charges before you drive off the lot.

If you have a trade-in, it could help reduce your capital cost, so think about adding this asset to your financial plan and remember to factor in additional expenses like gap insurance.

3. Analyze Your Driving Habits

Leases come with mileage restrictions, and it’s easy to underestimate how much you drive to save a few dollars. Being realistic about your driving habits is essential because you don’t want to be stuck with a big penalty for every mile you drive over the cap.

4. Do Your Research

The next step is where the fun begins. Do your research and figure out which makes and models appeal to you, just like you would if you were buying your car.

Look for options that hold their value because that retention can help lower your payment and remember that the car’s sticker price is only one factor to consider when shopping for a new car. Look at its dependability and safety ratings, too.

5. Check Dealer Inventory

Once you have a model or two in mind, it’s tempting to start visiting dealerships. Call ahead and make an appointment to ensure there are three or four options on the lot for you to test drive. You want to comparison shop before you choose.

6. Take Several Test Drives

Now it’s time to head to your local dealership and test-drive the cars. Let your salesperson know your goals, as they’re the experts. They may have an ideal option in their showroom that you haven’t considered yet.

7. Ask Questions

Entering into a lease agreement for a vehicle is a big financial responsibility, so it’s best to get your questions answered right away. Make a list as you’re doing your research, so you don’t forget any topics, like:

  • Residual value
  • Mileage limits
  • Early termination penalties
  • Maintenance responsibilities
  • End of lease options

8. Negotiate

One significant advantage or disadvantage with leasing is there isn’t a lot to negotiate, especially the residual value. This step can be stressful for many shoppers, so eliminating this process can be appealing. Still, it doesn’t hurt to ask for a new car lease deal to reduce or waive extra charges and inquire about:

  • Price
  • Money factor
  • Mileage limit
  • Down payment
  • Lease term

9. Finalize Your Lease

Once you’ve settled on a vehicle, sit down with your salesperson and confirm the details of your lease down to the penny. Make sure you understand all the terms, then sign the documents for your new lease. You’ll likely need proof of insurance to drive the car off the lot.

Mistakes to Avoid When Leasing a Car

Learning how to lease a car isn’t foolproof. There’s potential to make a mistake, so steer clear of these common pitfalls:

Failing to Budget

Like any major purchase, budgeting is essential. Depending on your agreement, you’ll likely need some cash upfront for multiple fees plus ordinary vehicle-related expenses. You’ll want to account for insurance, registration, sales tax, title, and dealer documentation fees.

Making a Big Down Payment

Making a significant down payment on a traditional car loan is a sound financial decision, but this isn’t so with a car lease. Save your cash and invest it or use the extra money to pay down other debt.

Opting Out of Gap Insurance

Gap insurance is a worthwhile investment whether you lease or buy a car. This product pays the difference between what your insurance company covers and your actual cost to replace if your vehicle is a total loss through theft or collision. If you’re lucky, your leasing company will include gap insurance with their contracts.

Exceeding Mileage Limits

It’s easy to talk yourself into an attractive lease payment on your dream car, but don’t underestimate how many miles you’ll put on your new vehicle. Riding your bike to work is a terrific idea, but what about that impromptu weekend trip to the mountains?

Just be honest with yourself from the get-go and opt for a lease that has a reasonable mileage allowance for your normal driving habits.

Not Maintaining the Car

Most leasing companies require the lessee to maintain the vehicle in stellar condition, and while you’re entitled to “normal wear and tear,” that term is subjective and up to the company’s inspector. Your contract may also stipulate that you cover repairs and maintenance, although most new leased cars have a manufacturer’s warranty.

Your contract may include free routine services, like oil changes, so confirm with your salesperson, and consider purchasing a damage protection plan. This supplemental car insurance coverage helps safeguard your pocketbook against minor damage.

Ending Your Lease Early

Leases are binding contracts, and breaking them before the end date will cost you. If you want to return your car early, you may need to make a balloon payment equal to the remaining balance of your lease. You’ll probably be responsible for other charges, too, like a disposition fee, and you can’t sell the car to make back the money because you don’t own it.

If used cars are in high demand, your dealership may be willing to make a deal and help you get out of your contract early. If not, there are online companies that broker deals for people who want out of their car lease, but that will cost you, too.

Leasing a Car for Too Long

If you over-extend your lease, you could also face serious monetary penalties, especially if you opted for a closed-ended type of agreement. What’s the worst-case scenario? Your leasing company could repossess your vehicle, negatively impacting your credit. Unfortunately, even a repossession won’t get you out of paying the bill on those fees.

How to End Your Lease

As you approach the end of the lease, you’ll want to make sure you’re ready. Basically, you have three choices. You can turn in the car, settle up and be on your way or you can buy out your lease and keep the car if you like it. The third and most common option is to leave in another newly leased car.

The dealership will likely call you to make an appointment for an inspection if you decide to return the leased car. Before you take it in, remove all of your personal items and any customized features you added, like a new stereo.

Have the car thoroughly detailed if you don’t feel confident doing it yourself, and make sure to have minor damage fixed ahead of time to lower any costs you’ll incur when you turn in your vehicle.

Now that you know how to lease a car, you can decide whether it’s the right choice for you. Whether you buy or lease has much to do with your personal preferences and financial situation.

If you want monthly payments and the freedom of a short term, leasing could be the answer. On the other hand, if you love those moments behind the wheel, cruising down the highway, beware of mileage limits.

Elizabeth Rivelli is a freelance writer with more than three years of experience covering personal finance and insurance. She has extensive knowledge of various insurance lines, including car insurance and property insurance. Her byline has appeared in dozens of online finance publications, like The Balance, Investopedia, Reviews.com, Forbes, and Bankrate.