By Allan Halcrow | American Express Credit Intel Freelance Contributor
5 Min Read | November 06, 2019 in Life
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.
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.
To understand the math behind that reality, it’s helpful to know some 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.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
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, 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
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.
1 “Buying vs leasing a car,” U.S. News & World Report
2 “How Does Leasing a Car Work?,” U.S. News & World Report
3 “Buying vs leasing a car,” U.S. News & World Report
5 “Lease vs. buy: What to consider when shopping for your next car,” CreditKarma
6 “Does Leasing a Car Affect Your Credit Score?,” Lendedu