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Understanding How Leasing a Vehicle Works

Authored by Jose Abuyuan on March 11, 2020

Ever considered leasing a car? You might have been discouraged by a friend.

Many consumers typically find car-leasing less favorable than purchasing one outright. This is because most buyers dislike the idea of paying for a vehicle they can't own. And even with the option to buy the vehicle, leasing is known to costs consumers more monthly than traditional financing over the life of the contract.

But before you completely check it off your list, it's important to understand how it works. Unless you've actually tried leasing a car, most people hardly know anything about the process, its benefits, and actual drawbacks.

In this guide, we'll discuss what car leasing it, how it works, and important processes and terms you should know about. We'll also rundown the pros and cons of leasing to help you know if this option can work for you.

What is a Car Lease?

Hand giving car and car keys

A lease is a contract you sign which specifies the terms you agree to use property owned by another party. When you lease a vehicle, it allows you to drive a car for a particular period of time in exchange for monthly payments. A car's lease term typically ranges between 2 to 4 years.

Unlike financing with the intent to own a vehicle, consumers lease to rent a car. In a typical lease, you must return the unit to the dealer once the lease term ends. This sounds simple enough, until you find out lease terms involve penalties and possible additional charges based on the car's condition upon return. Dealers also often impose penalty fees if you decide to take back the vehicle earlier than agreed.

There are many details you should know before deciding to get a lease. It also pays to do some research so you can negotiate a better deal before signing a contract. Here are the 2 main types of auto lease you can choose from:

Two Kinds of Auto Lease  

  • Closed-end Lease – Also called a ‘walk-away lease,' it's the most common vehicle lease in the market. It works traditionally, which means the car must be returned on the agreed end date. Under this arrangement, the unit's price is set by the end of the term. A lessee pays penalty fees if the vehicle is returned early or late, and if it incurs notable damages. Additional fees are also due if you run the unit above the agreed mileage. If the vehicle's value turns out less than the set price by the end of the term, you are not liable to pay fees.
  • Open-ended Lease – This lease provides a window time for returning the vehicle. For instance, if you secured an open-ended car lease for 3 years on January 10, 2019, you have a window time of 6 months to return it. This means you can take it back any time between December 2021 to June 2022 without worrying about penalties. An open-ended lease also does not set the vehicle's price by the end of the contract. Once the term ends, if the car's value is less than projected, you'll need to pay the difference between its actual value and its estimated worth. But if the car's value turns out more than projected, you may get a refund.

Thinking of Buying a Leased Car?

You must obtain a purchase option agreement from the dealer at the beginning of the lease. Getting one under a closed-end lease helps protect consumers with a set car price. This way, if the car's value turns out much lower than projected, a buyer can purchase the vehicle at the estimated lower price. On the other hand, since the price on an open-ended lease is not set, you have to pay the difference between the car's actual value and the estimated value. If it turns out more than projected, you'll need to pay the fair market price to buy it.

The Vehicle Leasing Process

Process of buying and leasing cars.

The standard lease process involves selecting a new car and applying to a leasing company via a dealership. It entails ironing out details such as specifying the lease term and the number of miles you are allowed to drive the vehicle. Then, you wait for approval, verify the terms, and sign the lease. And once you make a down payment, you can drive away with the car.

The summary above is an oversimplification, of course. There are a lot of details you need to know and attend to when you obtain a lease. Take note of the following measures to get you on the right track.

Make Sure to Have a Qualifying Credit Score

Just like in auto loans, you need a good credit score to apply for a vehicle lease. The average FICO credit score to obtain approval is 725. But if you have a score of 680 and above, which is still classified as good under FICO standards, you should be eligible for a lease. 

Familiarize Yourself with Auto Lease Terms

When it comes to negotiating a favorable auto lease, it helps to understand basic terms used in the contract. Once you speak with a dealer, they will refer to process terms that you might not be familiar with. Acquaint yourself with the following key terms:

  • Residual Value – When the lease starts, your lessor estimates the car's future value based on historical resale data. This is known as the residual value. It helps the lessor determine the vehicle's price by the end of the lease. A higher residual value estimate suggests the lessor anticipates lower depreciation during the time of the lease. They predict the unit will preserve its value better. 
  • Manufacturer's Suggested Retail Price (MSRP) – This refers to the wholesale price of the new unit, also known as the ‘sticker price.' Often, consumers are able to negotiate this price to a much lower amount. Don't believe a dealer if they say you cannot ask for a lower MSRP price. If you don't know how to start negotiating, try to do some research online. With a bit of effort, you'll know how much other people are paying for the same make and model.
  • Capitalized Cost – Also known as the cap cost, it refers to the base price or lease price of the vehicle. This is the price that you hope to get when you negotiate for a lower MSRP.
  • Money Factor – This is the interest rate or the lease counterpart of the annual percentage rate (APR). Take note, however, that the interest rate on a lease may be different from the interest rate on an auto loan. The money factor determines a huge part of your monthly lease payments. And just like in financing, the money factor relies a great deal on your credit rating. 
  • Lease term – Refers to the agreed time you will use the vehicle. It also states when your lease will end. While standard lease terms run from 2 to 4 years, terms are usually indicated in months (e.g. 24 months or 48 months). 
  • Mileage cap – Also referred to as mileage allowance, the lease contract specifies the maximum number of miles you can drive the car per year. The typical mileage cap for a private vehicle lease ranges from 10,000 to 15,000 miles per year. Exceeding the mileage cap means you can be charged between $0.10 to $0.50 per mile. But you can negotiate these figures.

Pigly's Tip!

Focus on knowing the cost, then try to negotiate the purchase price down. Do your research and ask around for the lowest price a particular unit can sell (there are plenty of auto sites for this). It's also a good idea not to disclose right away that you're planning to lease. Doing so may give the dealer other ideas to upsell your contract.

Prepare Yourself for Lease Payments and Fees

Man offering car and coins on a plate.

Vehicle leasing imposes certain payments and fees that is different from traditional auto loans. You might be surprised to find fees that don't come up in regular financing. Get to know these different costs to prepare yourself for the charges. These payments and fees include the following:

  • Down payment and other charges – Be prepared to make a down payment, pay license fees, and taxes. It may also include an acquisition fee, security deposit, and other charges. While the upfront cost for leasing is not as expensive auto loans, it can still rack up a hefty amount. And like auto loans, if you make a higher down payment, the monthly payments will be lower.
  • Rent charge – This is the amount you pay every month in on top of the car's depreciation. Other parts of your monthly payment may include use tax and other miscellaneous fees.
  • Disposition fee – This fee assists the dealer prepare to sell the vehicle. The disposition fee is charged when you return the vehicle. It pays for administrative costs, cleaning, storage fees, etc.
  • Other penalty fees and charges – These include early termination fees and wear-and-tear-charges. You may cover wear-and-tear on the vehicle if it goes beyond what's considered normal by the dealer.

Depreciation Determines Payments

Monthly lease payments are estimated according to the vehicle's depreciation rate. Car depreciation is the change in the unit's present value and its value by the end of the lease, which also includes interest and fees.

To break down the details of your vehicle's monthly lease payment, use the calculator on top of this page.

The Advantages and Drawbacks of Leasing a Vehicle

The table below highlights the pros and cons of leasing a car.

Pros Cons
The down payment is smaller, and the monthly payments are lower Will cost you more over the life cycle of the lease
You'll get warranty coverage and maintenance You don't gain equity/ownership through monthly payments
Allows you to drive the latest models that you would otherwise not be able to afford through a loan Not all contracts let you buyout your vehicle when the lease ends
There's lower maintenance cost for leasing new cars You may incur penalties and fees by the end of the term
Considerable tax advantages to company owners You're not allowed to customize the car
You don't have to worry about selling or trading in the car when the lease is through Getting out of an auto lease is costly

There are immediate benefits to leasing a vehicle but beware of the disadvantages. Consumers have various reasons for leasing. Since people have different needs, it's best to know which factors matter more before jumping into the contract. Take note of the following advantages and drawbacks before leasing a unit.

Advantages of Auto Leasing

Man with sunglasses in front of a luxury car.

Lower Down Payment and Monthly Payments

Leasing is usually the less costly option to drive a new vehicle. It allows you to use a new unit without putting up with a large down payment and costly monthly payments such as an auto loan. If you want to rent a car without the immediate commitment of purchasing it, this could work for you. People choose this option if they are not yet sure about owning a vehicle.

Get to Drive A New Model Every Few Years

Leasing is a great way to drive a sleek new car every couple of years without costing an arm and a leg. Standard car loans usually take around 5 to 6 years before you can completely pay them down. If you want to drive a new vehicle by 3 or 4 years, leasing might be a better option for you.

By the time a lease is done, you should have no costly financial obligations on the car. But of course, this is presuming the leased vehicle did not exceed the agreed mileage with no major damages.

Lower Maintenance Cost

Ideally, since the contract duration is short, your lease term should end before the car needs plenty of major fixes. Leased units are also guaranteed by factory warranty. This means you seldom have to worry about maintenance and repair costs while using the vehicle.

You Can Lease a Car Through Your Company

This is a good way to update your company vehicles more frequently without longer and more costly payments of a car loan.

When you lease a company car, its payments, interest, tax and maintenance costs are all tax deductible. This includes new breaks, tire changes, inspections, and oil changes. Even the amount of gas used for a company-leased vehicle is tax deductible. If you sell or trade-in a leased company car, you can claim a deductible loss.

Lower Depreciation Cost for Luxury Cars

Many luxury cars like Mercedes Benz depreciate a lot slower compared to sports cars, which makes the depreciation portion of the lease less expensive. This is less costly in terms of the percentage of value as the car ages.

Pigly's Tip!

There are car manufacturers that offer regularly maintenance schedules with no added costs for the entire term of a lease. Make sure to check with your dealer to confirm if your preferred car model comes with such a deal.

Car Leasing Drawbacks

Woman worried about dent in her car.

Auto Leasing Is More Expensive in The Long Run

By the end of the lease, you would have spent more than the amount on an equivalent loan. This is because you are driving an asset during its rapid depreciating years. If you consider costs on leases every couple of years, you could have spent those monthly payments to own a vehicle.

A major concern with leasing you do not gain equity of the asset. This is in contrast to getting an auto loan where you get more value off the car the longer you use it. In the end, it's more cost-efficient to buy a car and use it until it no longer works. 

Mileage Limitations

This lowers the vehicle's flexibility because you pay for extra mileage. If you use up less miles, you're not rebated. But if you use more miles, you're charged extra. You cannot go over a specified number of miles, or you'll deal with penalty fees.

Mileage penalty can range from $0.10 to $0.50 cents per mile. For instance, if you exceed by 2,000 miles, your penalty fee may cost between $200 to $1,000. You can easily spend thousands of dollars on penalty fees if you ramp up more miles.

Paying Excess Wear-and-Tear Charges

Driving with factory warranty does not excuse poor car maintenance. Even with free car checkups, you still have to keep the car in good condition. And in many cases, this can be a challenge especially if you rely on your vehicle on a daily basis. The more you use your unit, the more it will likely incur dings, dents, and scratches. And if you have children, you really have to be extra careful.

You Cannot Customize the Vehicle

Dealerships expect you to return the car in ‘showroom condition.' Forget about modifying the speakers or adding dash cams. Save for a few exceptions like professional window tinting, you cannot have new features or fancy tech fitted in the car. If you are keen on personalizing your unit, it's best to save up to buy your own car.

Early Lease Termination Costs Thousands of Dollars

If for some reason you need to relocate and cancel your auto lease, you'll have a hard time. Dealers exact steep penalty fees for early termination.

You'll need to make a hefty lumpsum payment just to get off the hook. It's almost like covering all the payments for the rest of the term. But if you really have to go, ask a trusted friend or family to look after the car for you (and not use it!). They can help you return it once the lease is due.

Pigly's Tip!

Most dealers won't allow you to break your lease without penalty. However, another way to break free is to transfer your lease. You can also try to buy out the car early and sell it to recover a portion of the costs.

Deciding What Works for You

Pigly in a car driving.

Now that you're aware of the advantages and drawbacks of leasing, you can identify situations where it's actually more beneficial than buying a car. This is particularly true for certain businesses that require company car service. They also need to update their units every couple of years.

Choosing whether to lease a vehicle largely boils down to your needs and priorities. For some consumers, it gives them the opportunity to try new models every couple of years without worrying about selling the unit.

On the other hand, there are those who prioritize ownership of a vehicle and require a more reliable long-term unit. But overall, staying in the cycle of leasing cars will eventually cost more than buying a vehicle.

Need more information about purchasing a vehicle? Read our complete guide to buying a car and use our car payment calculator.

About The Author

Jose Abuyuan is a web content writer, fictionist, and digital artist hailing from Las Piñas City. He is a graduate of Communication and Media Studies at San Beda College Alabang, who took his internship in the weekly news magazine the Philippines Graphic. He has authored works professionally for over a decade.

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