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How Do You Lease a Car and How Much Does Leasing 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

7 Min Read | November 06, 2019 in Life

 

At-A-Glance

When you lease a car, you’re paying to drive it for a fixed time period before returning it to the dealer.

How much a car depreciates in value while in your possession helps determine the cost of a lease.

Non-financial factors also influence the cost of a lease.

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.  

 

Why People Lease Cars

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

 

What Your Car Lease Pays For: Depreciation

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.

 

What Car Lease Math Looks Like

To understand how much it may cost to lease a car, it’s helpful to know some car leasing terminology.

  • 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 you’ll pay. If a dealer quotes you a money factor of .00125, multiply that by 2,400 to get the equivalent annual percentage rate (APR). Now you’re looking at a more familiar 3% interest. An online money factor calculator can do the math for you if you prefer.
  • Drive-off costs are what dealers label the down payment required, along with any other upfront fees you have to pay, such as DMV and leasing fees and a security deposit.

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.

 

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 but may be more than twice that.5 You can negotiate for higher mileage limits, but doing so may cost you more up front. Lower mileage limits can save you on the cost of the lease because cars with lower total mileage depreciate less.
  • Wear and tear limits. Dealers understand you can’t drive a car for three years without some minor deterioration from everyday use, such as a small stain or scratch that can be buffed out. 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.
  • 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.”

 

Car Leasing Is a Serious Commitment

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

 

The Takeaway

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.

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. 

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