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How Does Leasing a Car Work & How Much Does it Cost?

Learn more about car leasing, how it works, and what it means, as it can have a major impact on your credit report.

By Allan Halcrow | American Express Credit Intel Freelance Contributor

5 Min Read | November 06, 2019 in Life

woman with car

 

At-A-Glance

When you lease, you’re paying to drive a car—and for its depreciation.

You and the dealer have different goals.

Leasing may seem like less of a commitment than buying, but it’s still a big commitment.

So, you’ve seen more and more of your family, friends, and neighbors switch to leasing over recent years. You’ve read about the pros and cons of leasing versus buying a car and you’re leaning toward leasing. But how does leasing a car actually work?

If you can’t answer that question with something more detailed than, “I pay a monthly fee and get a car to drive,” then you may not be ready to sign a lease agreement. Leasing, like most modern relationships, can be surprisingly complicated. So before you make a final decision, let’s take the idea for a test drive to help you fully understand what you’re getting into.

 

As a Lessee, You’re Paying for Depreciation

Let’s start with the goals of a lease. Your goal may well be to have an affordable monthly payment in return for a car to drive. But the dealer has different goals. You’re going to drive a car off the lot, depleting the dealer’s inventory. Three years later, you’re going to return the car to inventory—but it will be worth a lot less than when you drove it away. The dealer’s goal, then, is to get maximum value from its asset.

To ensure that happens, the basic financial terms of a lease are structured so that the cost to lease a car—what you pay—offsets the depreciation.

 

The Math Behind the Cost to Lease a Car

To understand the math behind that reality, it’s helpful to know some leasing terminology.

  • The capitalized cost (or “cap cost”) is basically the price of the car. Discounts on that price—such as leasing incentives offered by the manufacturer—are known as cap cost reductions.
  • Residual value is what the dealer anticipates the car will be worth at the end of the lease.
  • Money factor is leasing lingo for the interest rate that you’ll pay. But if a dealer quotes you a money factor of .00125 you may feel a bit like Alice. To get out of Wonderland, multiply that by 2,400. Now you’re looking at a more familiar 3 percent interest. (If math is not your forte, just type “money factor converter” into your favorite search engine.)
  • Drive-off costs are what dealers label the down payment required, along with any other up-front fees you have to pay. 


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.1 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. Although many consumers don’t realize it’s possible when leasing, experts suggest that you negotiate for the best price even before you reveal your intention to lease.2

 

Non-Financial Terms That Can Impact Your Cost to Lease a Car

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:

 

  • Mileage limits. A typical lease will allow you to drive 12,000 miles per year, after which you’ll pay mileage penalties. Those penalties usually start at about 15 cents per mile and may be more than double that.3 That can add up quickly. You can negotiate for higher mileage limits, but doing so may cost you more up front. Lower limits can save you on the cost of the lease.
  • Wear and tear limits. Dealers understand that you can’t drive a car for three years without some wear and tear. However, they will likely charge you for certain kinds of damage or for what they deem “excessive” wear and tear. For example, you may be asked to replace worn tires. Also, don’t be surprised if you have to pay for damage to the glass or for dings that are larger than the size of a credit card.4
  • Restricted use. Some leases may not allow you to take the car out of the country without permission, or to use the car to drive for a ridesharing service, such as Uber or Lyft. 

 

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.”)

 

Leasing Is a Serious Commitment

Whatever agreement terms you negotiate, you may not want to take them lightly. A lease is a legally binding agreement, and typically structured to discourage people from walking away or returning the car early.

 

Suppose, for example, you wanted to return the car six months before your lease was to expire. In addition to any necessary repairs, you might well have to pay the remaining six lease payments and an early termination penalty.5

 

Finally, 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 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 score will likely take a big hit.6

 

The Takeaway

Leasing a car means a fairly complicated, serious commitment, but is often the best option for many people. Understanding what it really means to lease a car—including financial and non-financial factors that can all impact your total lease cost—can be very important to a car lease that meets your goals.

Related

Allan Halcrow

Allan Halcrow is a freelance writer concentrating in business, human resources, and diversity and inclusion. He is also the author of four books on management.

 

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express. 

The material made available for you on this website, Credit Intel, is for informational purposes only and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.