Financial Advice

Understanding Car Leases

Understanding Car Leases

When you are getting a new car, you have a big choice to make between buying and leasing. Assuming you cannot make the purchase in cash, buying or leasing can feel pretty similar because, in both cases, you are making a monthly payment for your car. However, there are some key differences between them, and it is important to understand how leasing a car works before you take out a lease.

On the surface, a lease looks a lot like a long-term rental agreement. You decide how many years you want to drive the car, and you pay a fixed monthly amount during those years. At the end of your lease term, you return the car and pay for any damage beyond normal wear and tear. You also will pay extra if you go over the mileage cap set in your lease.

However, there are some key differences between a lease and a long-term rental. One of the main differences is that you have control over several aspects of your monthly payments. When you lease a car, you are paying the leasing company for the reduction in the car's value over the course of your lease, but you can negotiate the starting value just as if you were buying the car. The other component of your monthly payment is interest on the value of the car. The rate you pay is based primarily on your credit score.

Key terminology you need to understand about leases:

  • Capitalized cost is the total cost of the vehicle when you start your lease. This will not necessarily be the manufacturer's suggested retail price. You can negotiate a lower capitalized cost, and you can even have rebates and other discounts applied to reduce your capitalized cost.
  • Residual value is the amount the car will be worth at the end of your lease. Many vehicles with a reputation for lasting a long time have fairly high residual value. Depreciation is the difference between capitalized cost and residual value. It is the amount of value your car will lose while you are leasing it, so you pay a portion of the depreciation with every lease payment.
  • The money factor, also known as the lease rate, is the number your leasing company will use to calculate the interest charges. If you want to convert the money factor into an interest rate, multiply it by 2400.
  • The lease term is the number of months you agree to have the car and make your lease payments. Leases are generally 36 months, though you can negotiate a longer or shorter lease if you would like. It is wise to not get a lease that is any longer than the bumper to bumper warranty coverage on the car you have chosen.
  • The annual mileage, also known as allowable mileage, is the number of miles you can drive per year of your lease before paying a penalty. Most leases allow 12,000 or 15,000 miles per year, and you could pay up to 15 cents per mile if you go over your limit.

Factors to consider as you look into car leases:

Leasing a car is ideal if you like to drive a new car every few years. It helps keep your monthly payments low and makes it very easy to bring in your car at the end of your lease and sign a new lease on a different car. On the other hand, if you could see yourself driving the car for five or more years, consider buying it instead. This allows you the freedom to drive it even longer than five years, and to own an asset that you can trade in to reduce the cost of buying your next car.

Your family situation should play a role in determining whether to buy or lease a car. For example, kids are messy, and they can cause damage to the car's interior that you would have to pay for at the end of a lease. Also, if you have a growing family, you may want to change to a different vehicle before your lease term is up, and it is very difficult to get out of a lease. On the other hand, if you have limited income now and just want a car to drive for a few years, low lease payments are a very attractive option.