By Allan Halcrow | American Express Credit Intel Freelance Contributor
7 Min Read | November 06, 2019 in Life
Car leasing is more like renting than owning – but it feels like owning. And it remains a popular way to finance a car regardless of fluctuations in the economy: slightly more than 30% of all new vehicles were leased in the first quarter of 2020.1 Perhaps you’re ready for a new set of wheels and are considering whether to lease it. But first it may be helpful to understand the mechanics of car leasing – what it means, how it works, the pros and cons, and, like any contract, the fine print.
A car lease specifies the amount of time a vehicle will be in your possession and the number of miles you can drive before incurring an extra cost. Why would you want this rental-style deal instead of buying? Generally speaking, the pros of car leasing over buying include a lower down payment and lower monthly payments. For example, according to Experian’s State of the Auto Finance Market report, the average monthly car lease payment was $466 in the first quarter of 2020, $103 less than the average monthly new-car loan payment.
Also, because a car lease typically only covers new cars under warranty, there are little or no additional costs for maintenance and repair. And car leasing is great if you enjoy driving the latest wheels on the market because the average length of a lease is 36 months – you might be moving on to the next model before you know it.
Of course, leasing a car doesn’t make sense for everyone. For example, experts say buying is less expensive over the long term, so buying may make more sense if you prefer to keep your car for longer than three years. If you buy, you can drive the car without mileage limits or penalties, and once you’ve paid off the loan, you own it. If you have a mediocre or poor credit history, you’ll probably find it easier to qualify for a loan than for a lease.2
Of course, how much it will cost to lease a car is an important consideration. That brings us to the concept of depreciation, which drives the long-term value of a car and the total cost to own one. From the second a car leaves a dealer’s lot, it begins to decrease in value. Vehicle depreciation is the rate of that decrease in value. Experts peg average car depreciation at around 20% in the first year of its lease and 10% each year thereafter.3 In other words, the car will be worth a lot less when your lease has ended.
The dealer’s goal is to get maximum value from the car when it’s returned at the end of the lease. To ensure that happens, the basic financial terms of a car lease are structured so the cost to lease – what you pay – offsets the depreciation. Since cars all depreciate at different rates, an online car depreciation calculator can come in handy for an approximation of the decrease in value before you head to the dealership.
To understand how much it may cost to lease a car, it’s helpful to know some car leasing terminology.
Now, let’s do the math. In simplest terms, the typical formula for how much it costs to lease a car is the capitalized cost minus the residual value plus interest and fees. For example, if your dream car has a cap cost of $35,000 and a residual value of $20,000 after three years, then you’re on the hook for $15,000 plus interest and fees.
Because your payment is driven by the cap cost, the lower the better. Experts suggest you negotiate for the best cap cost even before you reveal your intention to lease.4 If you plan to put the lease down payment on your credit card, keep in mind that dealers’ policies may differ. Some allow full payment, but others accept only partial payments, only let you use your card for fees and extras, or don’t accept cards at all.
Beyond the financial terms of the lease, the agreement will include components to help protect the car’s value. Conceptually, these are akin to the conditions you accept when you rent a car, but on a larger scale. These include:
Finally, be aware that the unique nature of leasing has implications for insurance, fees, taxes – which vary from state to state – and other costs. For more information, see “How To Lease a Car & Negotiate Your Lease Deal.”
Whatever agreement terms you negotiate, it’s important to remember that a car lease is a legally binding agreement and typically structured to discourage people from walking away or returning the car early.
Suppose, for example, you want to return a car six months before its lease expires. In addition to any necessary repairs, you might have to pay the remaining six lease payments and an early termination penalty.6
In addition, because leasing is treated as a loan on your credit report, it can impact your credit score. Whether that impact is positive or negative depends on how well you meet your car leasing commitment. Lenders looking at your credit report will see the total financial obligation of the lease, just as they would see the total amount financed if you bought the car. They’ll also see whether you’re making your monthly payments on time. If you terminate the lease early, it will report as if you defaulted on a loan, and your credit score will likely take a hit.7
Generally speaking, leasing a car may be a more affordable option than purchasing a car. Down payment and monthly payments are typically lower, plus you get to return it to the dealer after a set period and move on to the latest model. Car leasing is a legally binding commitment that requires looking under the hood at the impact of depreciation and the financial and non-financial factors that can impact your lease cost.
1 “State of the Auto Finance Market,” Experian
2 “Buying vs leasing a car,” U.S. News & World Report
4 “How Does Leasing a Car Work?,” U.S. News & World Report
5 “Buying vs leasing a car,” U.S. News & World Report
6 “Lease vs. buy: What to consider when shopping for your next car,” CreditKarma
7 “Does Leasing a Car Affect Your Credit Score?,” Lendedu