How Does Leasing A Car Work? (And Why You Shouldn’t Do It)

Leasing a car allows drivers to experience new car luxury and reliability with a potentially lower monthly payment than they'd face with a car loan.

However, that does not mean leasing is less expensive than buying a car. The lower lease payments cover the cost of depreciation on the car and the cost of financing. But the payments do not allow you to build equity in the vehicle. 

In this article, we explain how car leases works and why most cost-conscious drivers will want to avoid them. Here's what you need to know. 

Leasing A Car Means You Pay To Drive

When you lease a car, you’re paying to drive the car rather than paying to own it. While a car lease is a type of auto financing, it is not a traditional loan. 

During the lease period, you pay for the right to drive a car up to a certain number of miles. When the lease is up, you give the car back to the dealership. You never build vehicle equity when you lease the car. You simply pay to drive a vehicle.

When you take out a conventional auto loan, you OWN the car debt free at the end of the loan. By contrast, you will not own the vehicle you lease unless you exercise a purchase option (often involving a new loan) at the end of the lease.

Most leases limit you to driving somewhere between 10,000-15,000 per year. For example, a three-year lease may have a 40,000 mile limit. If you drive more than 40,000 miles during your lease, you will have to pay for the excess mileage.

What Happens When The Lease Is Up?

When your lease is up, you generally have three options:

• Exercise a purchase option. At the end of the lease, drivers typically have the option to buy the vehicle. Buying the vehicle is a great option if the value of the vehicle is more than the end-of-lease purchase price. If you don’t have the cash to buy the vehicle, you can take out a loan to buy it. Use Lending Tree to compare auto financing rates.
• Walk away from the vehicle. At the end of the lease, you can settle your account and walk away from the vehicle. You have no obligation to buy the vehicle or lease a new one from the dealer. This is the right thing to do if the vehicle is worth less than the purchase price of the vehicle.
• Start a new lease. Dealerships won’t always offer new lease deals, but many will offer certain incentives to get drivers to sign onto a new lease. When you return your vehicle, you have a certain amount of negotiating power to sign onto the new lease.

What Charges Can You Expect When Leasing A Car?

When you lease a vehicle, you’ll face upfront charges, monthly payments, and end-of-lease charges. We break them down below.

Upfront Charges

When you lease a car, you don’t make a down payment in the traditional sense. Instead, the money you pay upfront is called a "capital cost reduction."

The “capitalized cost” of a leased vehicle is basically the purchase price of the vehicle plus anything that’s added to the contract. When you trade in a vehicle or put money down, you reduce the capitalized costs.

When you pay money upfront, you get the benefit of lower monthly payments during the lease. That said, industry experts often advise leasees to limit their upfront payments.

Monthly Payments

The monthly payment is the amount that you'll pay in and out for as long as you lease the vehicle. The monthly payment will typically cover the following five costs.

• Depreciation: This is the amount of value the car loses due to wear and tear. 
• Service and insurance payments: It is common to pay for service contracts, car insurance and warranties as a part of the lease payments. The total cost of these expenses are baked into monthly payment.
• Interest fees: In a car lease, the interest is called a money factor. The money factor you see in your lease is tiny. Multiply the factor by 2400 and you’ll see your annual percentage rate on the lease. A money factor of .005 translates to a 12% APR.
• Use tax: When you lease a vehicle, you’ll usually pay a use tax rather than a sales tax on the vehicle.
• GAP insurance: Lessors may require lessees to buy Guaranteed Auto Protection (GAP) coverage. GAP insurance protects lenders if the leased vehicle is damaged or stolen, and traditional insurance doesn’t cover the full replacement cost. Since many leased vehicles are initially underwater, lessors may require you to buy this insurance.

Related: This Is The Real Cost Of Car Ownership

End-Of-Lease Charges

If all goes well, you can return your vehicle and never pay another penny. Unfortunately, many leasees drive too many miles or damage the vehicle during the lease.

If that’s the case, you will need to pay for excess mileage or unusual damage at the end of the lease. If you choose to buy the car at the end of the lease, you can forgo these charges.

Will I Lose Money By Leasing A Car?

When you compare a lease payment to a car payment, the lease payment is usually lower than the car payment. However, if you drive year in and year out for decades, leasing a car is the most expensive way to drive. 

When you lease, you are constantly paying for depreciation on a new vehicle. Vehicles depreciate more in the first few years of driving than at any other time. Additionally, you never build equity in the vehicle, so you’ll always have a payment.

Since lease payments are lower than loan payments, leasees may be tempted to upgrade to a nicer vehicle than they can truly afford. Leasing a sedan may cost just $300 per month, but buying it may cost $400 per month. If you can afford $400 per month, you may be tempted to spring for a luxury car lease rather than a sensible car purchase.

When Leasing A Car Could Make Sense

The one situation that leasing a car could make sense would be if you're someone who simply must always be driving the latest car model. If, for example, you plan to upgrade cars every two years, depreciation could make traditional car ownership unrealistic.

To be clear, switching to a new car every couple of years is going to be an expensive decision no matter how you slice it. But, for that unique situation, you may come out slightly ahead by leasing your vehicles vs. buying them.

Another situation is leasing a car for a business, where you can simply expense the monthly payments (and again, you'd probably be changing cars often).

Related: Why I Sold My Car And Uber Everywhere (Uber Vs. Owning A Car)

How To Find A Great Deal On A Car Lease

Without a doubt, leasing a car is often a great way to lose money over the long haul. But, if you’re considering a lease, there are ways to find leasing deals that can work in your favor. 

The best car lease deals will be on vehicles that have too much supply relative to their demand. Since we are in the middle of a global pandemic and an economic recession, there are a lot of great lease deals on late 2019 and 2020 models of vehicles. These are vehicles that dealers need to move to stay profitable.

Edmunds, a company that aggregates auto pricing information, keeps a list of vehicles that can be leased for less than $199 per month. As of the writing of this article, there are about a dozen vehicles (including trucks, sedans, and SUVs) on the list.

Final Thoughts

Leasing a car is convenient, but it can be really expensive. Most people who are working on building their income and their wealth shouldn't be leasing cars. It simply doesn't usually make sense from a financial perspective.

Saving cash to pay for a used vehicle is usually the most affordable choice. Of course, buying a sensible and reliable new car that you can pay off in four years or less may make sense too. For more car buying tips (especially if you have student loans that you're paying down), check out our complete guide.