What is car leasing?

Woman driving her car with her dog sitting in the front seatImage: Woman driving her car with her dog sitting in the front seat

In a Nutshell

Want to drive a new car without the big monthly payments that can come with car ownership? Leasing a car can in many cases allow you to drive a new vehicle for less per month than you would with an auto purchase loan for the same car. But when the lease ends, you won’t own the car — unless your lease contract gives you the option to purchase the vehicle from the dealer.

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When you lease a car, you’re paying to drive a new vehicle — not to own it.

A car lease is a popular type of auto financing that allows you to “rent” a car from a dealership for a certain length of time and amount of miles. You’ll typically make monthly lease payments on a vehicle, and in exchange the dealer allows you to drive it. At the end of the lease, you’ll either return the vehicle to the dealership or buy out your lease if you want to keep the car, if that’s an option in your lease.

You’ll typically need good credit to lease a new car. People leasing a new vehicle in the third quarter of 2020 had an average credit score of 733, according to Experian data. FICO considers scores of 670 and above to be “good.” Keep in mind that even though you don’t own the car you’re leasing, your lease-payment history will show up on your credit reports.



How is a car lease different from a car loan?

In many ways, a car lease is similar to an auto loan. For example, as the person leasing a vehicle — also known as the lessee — you may have to put cash down for the car, and you’ll make monthly payments just as you would with a typical car loan.

Leases often have lower monthly payments than a car loan — but those lower payments have a downside. Instead of building equity in the car, you’re only paying for the privilege of driving it for a set amount of time and miles.

While you can often apply for car-loan financing through a bank or other third-party lender in addition to a car dealership, it’s uncommon to arrange a car lease through a bank. Instead, you’ll most likely work directly with a dealership or a specialized vehicle-finance company.

At the end of the lease term — typically two to four years — you’ll return the car to the dealership and walk away from the car and monthly payments for good, unless your lease allows you to purchase the vehicle.

Can I lease a used car?

It’s possible to lease a used car. Edmunds recommends working with a franchised dealership to arrange financing on a certified pre-owned car. Examples of franchised dealerships could be BMW or Toyota.

Lease-here, pay-here” dealerships tend to lease used vehicles to people with bad credit — but these leases are often filled with “gotchas.” It’s generally best to avoid leasing from these types of dealers.

What terms do I need to know before leasing a car?

If you haven’t leased before, a car-lease agreement can be full of unfamiliar language. Before taking out a lease, here are some terms to know.

Open-end vs. closed-end leases

If you’re considering leasing, you’ll want to verify if your terms are for a closed-end or open-end lease. With a closed-end lease, you typically don’t pay any more after you return your vehicle — unless it has excessive wear and tear or you went above any mileage limits.

A closed-end lease means you’ve already agreed on how much the car’s value will decrease during your lease term. If the car is worth less than your agreed-upon amount when you return it, you have no additional financial obligation.

With an open-end lease, the future value of the car isn’t in the contract. At the end of an open-end lease, you may get a refund if the vehicle is worth more than expected. But if the car is worth less than expected, you may have to pony up more cash.

Capitalized cost

Your lease contract can include a number called the gross capitalized cost, which is comparable to the agreed value of the car and services at the start of the lease. The gross capitalized cost includes the value of the car plus the value of any other services and fees defined in the lease.

A related term is capitalized cost reduction. It’s possible to reduce your gross capitalized cost — and monthly payment — by applying a capitalized cost reduction. Capitalized cost reductions are subtracted from the gross capitalized cost to calculate the beginning lease balance — they kind of function like down payments on a lease. If you trade in a vehicle or put cash down, your gross capitalized cost will be reduced by the amount of the capitalized cost reduction.

Residual value

Residual value is the value of the car at the end of a lease agreement. A car that holds its value well has a high residual value. You and the lessor will typically agree to a residual value at the start of a lease agreement, and the car’s residual value will be in the contract.

Depreciation

Depreciation is the rate at which your vehicle loses value over time. If you’re leasing, you’ll pay for the depreciation on the vehicle through your monthly lease payments.

Rent charge

The rent charge — also known as the money factor — is the largest cost of leasing a vehicle and is similar to interest. You can figure out your equivalent annual percentage rate, or APR, by multiplying the money factor by 2,400.

Use tax

There may be a use tax when you take out a lease. In most states, the use tax usually replaces the sales tax that most people pay when buying a vehicle.

Guaranteed Auto Protection (gap) coverage

The lessor may require you to purchase gap insurance, which covers the difference between the amount you owe on your lease and the actual value of the leased vehicle if it is damaged or stolen.

Early termination charges

When you take out a lease, you’re agreeing to pay for the lease for a certain period of time. If you end the lease early, you may have to pay an early termination fee. Your lease agreement should explain what amount you’ll owe if you choose to end the lease before the term is up.

What happens at the end of my car lease?

When a lease is up, you have two options.

  1. Buy the car. Most of the time, leases give you the option to buy the car at the end of the lease. If you don’t have the cash to pay for the car, you may be able to apply for a lease buyout loan to buy it.
  2. Settle the account and walk away. The end of a car lease may be as simple as returning the car to a dealership and walking away. But in some cases you may have to pay if you drove more than a certain mileage limit, which is usually between 10,000 and 15,000 miles a year. The exact fees for excess mileage will be defined in the lease contract. You may also have to pay for excessive wear and tear if you turn in the vehicle in poor condition.

Is leasing right for me?

Even though monthly lease payments are usually lower than car-loan payments, leasing may be more expensive than an auto loan in the long run.

When you take out a car loan, you’ll pay off the car over time. Driving a vehicle you own can reduce your long-term costs since you’ll no longer have a monthly payment once your car loan is paid off. But if you lease a car, you won’t be building equity in a vehicle.

Depending on your desires and lifestyle, it can still make sense to lease instead of buy. Here are a few times to consider leasing.

  • You want to drive new cars. If you exclusively lease new vehicles, you’ll enjoy the benefits of a new car without the hassle of selling a used vehicle each time you trade up.
  • You don’t want to own a car. If you view car ownership as a hassle, a lease may be a good choice for you. Lease agreements may include service contracts that can make dealing with maintenance and repairs more convenient.
  • You need a car for a short time. Perhaps you’re living somewhere short term and need a car. In that case, taking out a two-year lease may make more sense than buying and selling a car.

Bottom line

As you search for your next car, consider if a lease makes sense for you. Just remember that at the end of a lease, you won’t automatically own the car. Consider your lifestyle, whether you want to own a car and your budget before deciding whether to lease or buy a new car.


About the author: Hannah Rounds is a freelance writer who covers consumer finance, economics, investing, health and fitness. She received her bachelor’s degree in economics from Furman University. Read more.