How Does a Car Lease Work?

Posted by in Auto | Updated on August 14, 2023
At a Glance: Car leasing is an agreement where you make an upfront payment and monthly payments to a lessor for the use of a car for a specified period. At the end of the lease, you return the vehicle. The monthly payments are based on the car’s depreciation, plus interest and fees. Leasing offers lower monthly payments, smaller down payments, access to new cars with the latest technology, and manufacturer’s warranty. However, it has long-term cost implications, upfront depreciation payment, fees and penalties, termination fees, and no ownership of the vehicle. Consider personal circumstances and credit score before deciding to lease a car.

So, you need a car. Deciding between buying and leasing a car can be difficult. You may be asking yourself: how does a car lease work?

Leasing a car is like a long-term rental agreement. Leasing a car is a good option if you want a new car with the latest technology. A good lease can offer you low down payments and low monthly payments. You don’t own the car, but you’ll be able to return the car after a few years. You can then decide to get another lease on a new car with the latest technology.

Let’s take a closer look at how does a car lease work.

What Is a Car Lease?

How does a car lease work? When you lease a car, you have an agreement with the lessor (the company that buys and owns the car). You’ll generally have to make an upfront payment, plus monthly payments on the lease. You’ll be able to use the car for several years and at the end of the lease, you’ll return the vehicle. You can then decide if you want to start a new lease, purchase a car, or go carless.

When you lease a car, your monthly payment will be calculated based on the car’s depreciation, plus interest and fees. You are responsible for paying the depreciation between the purchase price of the car, and its value at the end of the lease.

How does a car lease work in practice? Between you and the lessor, you determine the capitalized cost and the residual value. The capitalized cost is the price you are paying for the car. You should negotiate aggressively to get the capitalized cost as low as possible. The residual value is the price the lessor will pay to “buy back” the car at the end of the lease. The residual value is set by the manufacturer and you should confirm that the lessor is using the correct residual value.

In effect, you are “buying” the car and then “selling” it back to the lessor at a pre-specified price at a pre-specified time. However, car ownership doesn’t actually transfer to you – the lessor keeps ownership of the car at all times.

What Are the Benefits of Leasing a Car?

Leasing a car can be more appealing than buying for several reasons:

  • Lower monthly payments – The monthly lease payments will generally be lower than the monthly loan payments for the same car.
  • Smaller down payments – A car lease may require a smaller down payment than purchasing a car with a loan.
  • New car with the latest technology – You may be able to afford a new car with the latest technology. If you always want to drive the latest-model car, a lease could be less expensive than buying and selling a vehicle every couple of years.
  • Manufacturer’s warranty – Your car will generally be covered by a manufacturer’s warranty.

What Are the Disadvantages of Car Leasing?

Before you lease a car, however, you still need to consider the disadvantages of leasing the car. 

Leasing a car might not be best for your needs for several reasons:

  • Long-term cost – In the long run, leasing will cost more than buying and holding on to a car.
  • Paying depreciation upfront – You are paying for the depreciation at the beginning of the car’s life when it depreciates the most.
  • Fees and penalties – What you can do with your car is limited. You may have a mile limit, or have to pay extra for wear and tear, or pay administrative fees.
  • Termination fees – If you don’t need a car anymore, getting out of a lease can be expensive.
  • Ownership of the car – You don’t own a car or have an asset once the lease ends. 

Leasing vs. Buying: What the Experts Say

Whether leasing or buying a car makes more sense depends on your personal situation.

Kevin O’Leary, O’Shares ETFs Chairman and “Mr. Wonderful” on Shark Tank, says the first thing you should do is “consider is how long you think you will have the car. The longer you plan to keep it, the more sense it makes to buy.”

For example, O’Leary recommends leasing a car if you’re going to want a new one in three years. If you’re going to keep a car long-term, for example, if you collect cars, then buying it makes more sense.

As explained above, leasing is also often cheaper than making payments on an auto loan, which is another factor to consider. Though you won’t be building up any equity in the car, like you would if you bought it, you can save some money for the time being.

What Credit Score Do You Need to Lease a Car?

Just like taking out a car loan, leasing may be easier and less expensive if you have good credit.

Generally, car leasing companies prefer customers who have a credit score of at least 700. Higher scores can help you qualify for a lower monthly payment.

How does a car lease work? Your credit score doesn’t affect the capitalized cost or residual payment. Your credit score does influence what is known as the money factor. The money factor is the rent charge on a car lease. It is similar to an interest rate on a car loan. The better your credit score, the more likely you are to get a good deal on the money factor of a car lease.

Some lessors offer leases on used vehicles, which may be easier to qualify for if you have bad credit. Or you can try to improve your credit before looking for a lease. Or consider purchasing a used car that’s a better match for your budget.

Considerations Before Leasing a Car

Once you’ve weighed up the advantages and disadvantages of leasing a car, there are a few final considerations you should take into account before signing the lease. 

Some lessors will charge an “acquisition fee” – an upfront fee for arranging the lease. Make sure you work this into your budget and cash flow.

Remember to negotiate your capitalized cost (sometimes referred to as cap cost) to get the best deal. These strategies are known as cap cost reductions.

There can also be a bunch of hidden costs included in a car lease. For example, you may have to pay a security deposit, a disposition fee, or purchase gap insurance. Make sure you understand all of the costs in your lease agreement and see if you can negotiate for some of the costs that don’t suit your needs to be removed.

Some lease agreements include a mileage allowance. A mileage allowance is how many miles you’re allowed to drive each year before the per-mile penalty begins. You can sometimes negotiate a higher mileage allowance.

The lessor defines normal wear and tear and how much you’ll have to pay if there is excessive wear and tear. If you smoke in the car, have kids or pets, or park on a busy street, you increase the chances of paying wear and tear penalties.

How to Lease a Car

If leasing a car sounds like the right option for you, here are some steps to take to prepare for your car lease:

  • Check your credit score to make sure you qualify to lease a new car. 
  • Determine how much you can afford to put down and how much you can afford to pay each month.
  • Make sure you know what your driving behaviour will be. Consider how many miles you drive and whether you are likely to incur wear and tear penalties.
  • Test drive different cars to find out which make and model you’d like to lease.
  • Shop around to see which dealership will offer you the best lease terms. You need to consider all of the factors that go into a car lease – the capitalized cost, the money factor, the monthly payment amount, the fees, the residual value, and the down payment. Make sure your lease offer performs well over all of the factors.
  • Sign the best lease offer. Be sure to read the entire agreement and make sure it reflects what was promised during the negotiations.

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Congratulations! You can now answer the question “How does a car lease work?” and you are ready to go looking for a car lease.

Make sure you shop around for the best deal. You need to consider all of the factors that go into a car lease – the capitalized cost, the money factor, the monthly payment amount, the fees, the residual value, and the down payment.

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Frank Gogol

I’m a firm believer that information is the key to financial freedom. On the Stilt Blog, I write about the complex topics — like finance, immigration, and technology — to help immigrants make the most of their lives in the U.S. Our content and brand have been featured in Forbes, TechCrunch, VentureBeat, and more.