How Does Leasing a Car Work: A Simple Guide
11 MIN READ
Published January 11, 2024 | Updated January 29, 2024
If you’re not interested in purchasing a car or prefer to enjoy the benefits of a new model every 2-3 years, car leasing may be a good option. So, how does leasing a car work? Leasing works very much like renting an apartment, where you make monthly payments in exchange for temporary use of the car.
Before you sign a lease agreement, it’s important to understand how this option works, how to apply for a lease, factors that may impact the overall cost, and your options at the end of the lease. In this guide, we’ll provide you with in-depth information about these points.
What Is Car Leasing?
Unlike buying a car, when you lease a car, you’re paying for the right to use the vehicle for a fixed period of time. You’ll make monthly payments, similar to a car loan payment, but you won’t have ownership of the car.
At the end of your lease term, which is usually 24-36 months long, you will be required to return the car to the dealership (in very good to excellent condition), just like you would return a rental car to the airport at the end of a business trip or vacation.
When you return the vehicle, you will pay any end-of-lease fees that may be due for excess wear and tear or for the extra miles you’ve driven over the mileage limits specified in your lease contract, if any.
When you lease a vehicle, the monthly payments are calculated based on the car’s projected depreciation plus fees and interest.
How Does a Car Lease Work?
A car lease is a contract between the car dealership (lessor) and you (lessee). So, how do car leases work? When you sign the lease agreement, you agree to some conditions, such as:
- Monthly payments
- Maintenance requirements
- The lease term
- How many miles you can drive each year
- Penalty for exceeding mileage limits
- Early lease termination rules
Your car lease may also mention your options at the end of the lease term, such as whether you can extend the lease, enter into a new lease for a different car, or exercise your purchase option.
What Happens at the End of the Car Lease?
When your car lease is up, you have two main options to choose from: you can simply return the car to the dealership and walk away, or you can purchase it outright at its residual value, which we’ve discussed below. This is different from breaking a lease, where you terminate your lease agreement before the end of the term.
If you’re wondering how to break a lease, there are four main options that you may consider:
- You can simply return the car to the dealership, though this may be expensive.
- You can request voluntary repossession. However, this may hurt your credit.
- You can roll your remaining payments into a new car.
- You can find another buyer for a lease takeover transaction.
- You may be able to purchase the car outright (in effect, “buying out” your lease) at any point in your lease term for some predetermined price if your lease contract allows for this option.
“If you agree to sign a new lease for a newer vehicle with the same automaker or dealership, many leases allow you to terminate early and upgrade without paying early termination fees,” explains Brad Reichert, a financial expert and the founder and managing director of Reichert Asset Management.
Return the Vehicle to the Dealer
At the end of your lease period, you can return the vehicle to the dealership. You may have to pay additional fees based on the car’s condition and mileage or how many months you have left in your lease term. Some leases will allow you to return your car early and without penalty/fees if you do so within the last 3-6 months of your lease contract. Your auto lease documents will always specify the exact fees you must pay, depending on how and when you decide to break your lease.
If your car is in poor condition when you return it, you may also have to pay for excessive wear and tear. The leasing company may also charge a disposition fee, which covers the cost of cleaning and repurposing the car for resale. The fee is usually around $350-$400 but will depend on the dealership, your location, and the car model.
This option may be right for you if you don’t want to continue driving the car or prefer to lease or purchase a different car.
Purchase the Car
In most cases, you’ll have a lease buyout option at the end of the term. Whether you should purchase the car will depend on whether you like the vehicle you’re driving and if your financial situation allows you to make that purchase.
Consider whether it may be better to purchase the car you’ve leased or a new vehicle by comparing your car’s residual value, as specified in your lease contract, to your car’s current value.
If your car’s current market value is considerably higher (e.g., $5,000 or more) than what you can buy it for at the end of your lease, you may consider purchasing it and then keeping it or reselling it for a profit and recouping some of the expenses you paid as part of your lease.
You can apply for a lease buyout loan if you can’t pay for the car upfront with a lump-sum cash payment. With a lease buyout loan, you’ll continue making monthly payments, this time on your new buyout loan, but you’ll own the car free and clear once you pay it off.
4 Easy Steps To Leasing a Car
Now that we’ve established how a lease works, it’s also important to understand the leasing process. Many of the steps involved in the process are similar to how car loans work. Start by setting a budget to determine how much you can afford to pay each month. You can then follow the four steps we’ve outlined below.
1. Check Your Credit Score
In most cases, car leasing companies and dealerships require you to have a credit score of at least 700 in order to be approved for most leases. You may qualify for the most attractive promotional lease deals if you have very good to excellent credit (a FICO score of 750 or above).
However, like auto loans for bad credit, some dealers offer leases for used vehicles, where you may be able to qualify even with lower credit scores. Be sure to get a copy of each of your credit reports from all three credit bureaus to understand your options.
2. Research and Choose a Vehicle
Consider your intended use of the vehicle and how many miles you typically drive each year to select the right car. Use this information to research and choose a car model that suits your needs and budget.
Think about the car’s interior features, safety technology, and fuel efficiency, as well as the color and convenience/performance packages you want. Then, check if the dealership offers any incentives or special lease deals available–these usually come at the end of the model year (November to January), when next year’s models typically hit the showroom floor.
Request quotes for the cars you’re interested in from multiple dealerships and leasing companies. Use these quotes to negotiate the final terms of the lease. Compare open-end leases and closed-end leases before you make a decision.
3. Negotiate Lease Terms
Just like you can negotiate with the dealer to reduce your car loan payments when purchasing a car, you can also negotiate most (but not all) of your lease terms, such as
- Your down payment, sometimes referred to in your lease contract as a “capitalized cost reduction”
- The vehicle sale price, referred to in your lease as the “gross capitalized cost”
- End of lease purchase or lease extension options
- Mileage limits
- Length of the car lease (the term)
Check your credit score before you negotiate a lease so you’re prepared. The higher your credit score, the more negotiating power you have. The average term for a car lease is 24-36 months. Longer terms mean your monthly payments will be lower, so you may want to negotiate an appropriate term length for your needs and expected driving habits.
4. Sign the Lease Agreement
Once you’ve negotiated the terms of the lease, it’s time to sign the agreement. Make sure you read the agreement carefully and pay attention to the capitalized cost, monthly payment, down payment, lease incentives (cash back), and the money factor.
It goes without saying that you should not sign any documents unless you’ve verified that the information is complete and accurate. Once you sign the lease agreement, it’s legally binding, as with any other legal contract.
Benefits of Leasing a Car
There are several benefits of leasing a car, which makes this an appealing option for many:
- When comparing leasing vs. buying a car, lease payments are usually lower than loan payments.
- You’ll need a smaller down payment for a lease compared to purchasing a car.
- Leasing is a less expensive option than purchasing if you prefer driving the latest model vehicles.
- You won’t spend much on maintenance costs because most new vehicles sold today come with complete “bumper-to-bumper” warranties against any mechanical problems for the first 36 months or 36,000 miles, so any potential expenses related to the repair or replacement of any parts or components on the vehicle are covered by the carmaker during the first three years of the vehicle’s life. Many automakers provide complimentary maintenance services (i.e., free oil changes, tire rotations, etc) for the first 2-3 years, as well.
- You’re not required to trade in or sell the car at the end of your lease.
- You can get a short-term or long-term lease, depending on your needs.
Drawbacks of Car Leasing
While there are many benefits, leasing a vehicle isn’t for everyone. Consider these cons of leasing:
- You won’t own the car.
- You’ll have to pay hefty penalties if you customize or make any changes to the vehicle during the lease.
- If you don’t want the car anymore, you’ll have to pay an early termination fee to end the lease.
- Leasing often costs more in the long run compared to purchasing and holding a car for a longer duration (7-8 years or more).
Factors Affecting Lease Payments
The monthly payments for leasing a car depend on several factors. It’s important to be aware of how they can impact how much you’ll end up paying each month.
Depreciation and Residual Value
The depreciation and residual value of the car are closely related. The residual value is what the car is projected to be worth at the end of your lease, while the depreciation amount is how much value the car is expected to have lost by the time the lease ends.
We’ve provided an example below to explain this clearly:
Let’s consider that you want to lease a vehicle with a selling price of $40,000. You lease the vehicle for three years, and at the end of it, the car is projected by the leasing entity (a bank or the automaker’s finance company) to be worth $25,000, which is the residual value.
The depreciation of the car is the selling price minus the residual value ($40,000 - $25,000 = $15,000).
Your lease payments cover this depreciation over the term of the lease, so it’s important to determine both these values before you lease the car. Use a lease buyout calculator to determine if it makes financial sense.
Mileage Limits and Excess Charges
Automobile leases usually come with mileage limits, unlike an auto loan, where you can drive as many miles as you wish without restriction.
When you exceed the number of miles specified in your agreement, you may have to pay excess mileage charges that can vary based on the model and type of vehicle. Determining your expected annual mileage, based on your normal driving habits, before you sign the lease agreement is an important way to avoid these charges.
Car Lease Vs. Car Loan
If you need a vehicle, it's important to understand the key differences between a car lease vs. car loan to determine which option is right for you. In both cases, you’ll need a down payment and will make monthly payments.
However, car leases often have lower monthly payments and lower down payments. With a car loan, you’ll build equity in the vehicle, but with a lease, you’re only paying to be able to drive the car for a fixed period of time.
Another key difference between the two options is that with a car loan, you’ll retain ownership once you pay off the loan. With a lease, you’ll need to return the vehicle to the dealership or purchase the car if your lease offers that option.
Is Car Leasing a Good Idea?
While you’ll typically pay lower each month if you lease instead of buy, leasing can often be more expensive in the long run. However, depending on your lifestyle and personal preferences, it may make sense to lease.
Here are a few situations where leasing may be a good idea:
- You only need a vehicle for a short time.
- If you plan to use the vehicle strictly for business purposes, a lease can offer certain tax benefits versus taking depreciation on a vehicle your business would purchase outright or finance through a loan.
- You prefer not to own a car or not have to worry about what you can get for it as a trade-in when you upgrade to a new car.
- You like driving new cars and don’t want the hassle of paying for expensive mechanical repairs and maintenance as the car gets older.