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How Does Leasing Work

Updated: Mar 16, 2021

If you’re confused by the car leasing process, you’re not alone! We’re programmed to measure a price. But, if you’re thinking about leasing the price is only part of the puzzle. That’s why I’ve written this post, how does leasing a car work.

When you’re considering a new car there’s two paths you can choose:

  • Leasing

  • Purchasing

What makes leasing appealing?

Many people enjoy leasing cars because they consistently drive a car that’s relatively new, 3-years old, or younger.

Additionally, someone who leases a car pays less tax than someone who’s purchasing the same car.

Purchasing a new car is similar to any other type of transaction. You agree upon a price, and if necessary you finance the cost of the car over time.

Leasing is somewhat different because you’re not going to take ownership of the vehicle. Rather, you will be paying to use the car for a period of time.

Leasing sounds great, and you might be asking your self, “why doesn’t everyone lease their cars?”

Leasing is not your best choice if you:

Plan on putting high miles on the car – typically anything more that 15,000 miles per year. Tend to be rough on cars – if you typically end up with lots of dings and scratches on your car, leasing might be very expensive! So, the typical person who’s ideal for a lease is someone who’s commute isn’t very far, and you’re willing to commit to maintaining the car’s interior and exterior, then leasing may be right for you!

Exactly What is a Car Lease

When you’re leasing a car you’re paying the difference between the purchase price, and the car’s anticipated value at the end of the lease, in other words, the depreciation of the car. Of course there’s also fees, taxes, etc. As a new car shopper, be sure to get all of my buying assistance, click here.

pros and cons to leasing a car

Leasing – How Does it Work

To ensure you understand how leasing a car works, let’s take a deeper dive.

If you’re leasing a $45,500 new car for 39 months, and the car’s residual (it’s anticipated value after 39 months) is $31,000 your lease payments will be based on the difference of the purchase price ($45,500) and the residual ($31,000) or $14,500.

Purchase price – $45,000 less Residual Value $31,000 = $14,500

You need to add in fees including:

Cap Cost Reduction – the amount you put down at the start of the lease to reduce the cost

Lease Origination – also called Bank Fee and Acquisition fee. This is a fee that is paid to the lending company extending the lease to the customer.

Lease Termination – Also paid to the lending arm when you end your lease.

Security Deposit – could be refunded at least end, it ensures that the vehicle will be returned in the necessary condition. A security deposit protects the lender from having a car returned in a condition that’s worse that expected. If you exceed the allotted mileage, or the car is damaged in any way, you will be asked to pay to have it repaired, the security deposit is an insurance policy to protect the lender.

Additionally, you can expect to pay taxes, and fees associated with paperwork and the registration of the vehicle, including title, plates and registration.

Some additional Leasing terms you should understand include:

Leasor – the bank that’s providing the lease

Leasee – the customer leasing the car

Cap Cost – is the lease term for purchase price. Just like the purchase price, the Capitalized Cost should be negotiated just like a purchase price. If you’re not sure the best way to do this, check our my New Car Buyer’s Course!

Cap Cost Reduction – This is similar to the down payment for a car you’re financing through a purchase. It accomplishes the exact same thing, it reduces your monthly payment by providing money at the start of the lease. If you’re planning on trading in a car, this is were the trade-in value is used.

For example:

Cap Cost $14,500

Trade-in is worth $4,500, used for Cap Cost Reduction creates a net figure of $10,000

Term – as in all loans and financial agreements that require payments, your lease will have a predetermined number of monthly payments, known as the lease term. Earlier the example I used was a lease term of 39 months. The vast majority of leases run from 24 to 45 months. If a lease is too short, you’re going to pay a premium because of the drop in value a new car inquires the moment it’s registered. And, if the lease goes for too long, the car’s value drops, predominately due to mileage.

Money Factor – if you purchase a car your car loan has an APR, an interest rate. This is part of the lender’s profit. When leasing this profit source is called the Money Factor.

Mileage Limit – sometimes called a mileage cap, this the number of miles included in your lease. This is one of the two factors that can dramatically alter the amount you pay each month. The more miles allocated per year, (usually 10,000 to 15,000), and the longer the lease, the higher your monthly payment will be. If you go over the total allotted miles you will pay a significant penalty about $0.25 per mile over the mileage max.

Buyout Price – A lease contract provides you with the option to purchase the car at the end of the lease, and this number is set at the lease’s inception. Many times when someone’s far exceeded their mileage limit, or if the car has a lot of cosmetic damage, paying the buyout price is the smart financial decision.

Here’s something extremely important, there’s two types of leases, and you should NEVER enter into one of them.

The two types of leases are:

  • Open Ended Lease

  • Closed End Lease

The open and closed refers to the value of the car at lease end. You want this number established at lease origination, NOT at the end of the lease! With a closed end lease, assuming the mileage and vehicle condition are as expected, you have the right to turn in the car and walk away.

In an open ended lease the value of the car is determined at the end of the lease, and I’m sure you can see, the odds are you will need to make an additional payment if you want to walk away from the car!

how does car leasing work

Comparing Leases

If I asked you this question, “How does leasing work,” you would be able to give me a great answer!

But, when you’re considering buying, or leasing a new car it’s critical to get more than one price, so let’s examine how to compare lease quotes.

When you want to compare leases from two different car dealers don’t just look at the monthly payment!

Let’s create two leases and we’ll compare them.

Lease #1

Monthly Payment – $349/mo – 39 months

Lease #2

Monthly Payment – $299/mo – 24 months

Let’s start with the premise that you do not have enough information to compare the two leases, so you need to peel back the onion and get more information.

Start at looking at the Capitalized Cost, or the Cap Cost. In 99% of the cases when comparing two leases the one with the higher Cap Cost is not the best option. All you’re doing is comparing two numbers. For our comparison let’s assume they’re the same.

Additionally, you would want to look at CCR, Cap Cost Reduction. This is money you’re going to provide at lease signing. For this example let’s say they are the same. If not, when we look at the total payments add the CCR in for both deals.

Step two would be the simple calculation of the total monthly payments.

Lease #1 – $13,611.00

Lease #2 – $7,176.00

As you can see, there’s a real discrepancy in the amount you’re going to pay, but WAIT, we can’t really compare them yet, let’s keep going!

The picture is going to get much clearer once we take a look at the number of miles allowed per year. This is important to understand, the payments are reflected as an amount per month, and mileage is reflected per year. So, I like to take these numbers and convert them into the same time period.

In our example, Lease #1 includes 12,000 miles a year, Lease #2 comes with 9,000 miles per year.

So, let’s turn the mileage into the same monthly number that the payments are in, and you’re going to see the picture become clearer!

Lease #1 is 12,000 miles per year, and that’s 1,000 miles a month

Lease #2 is 9,000 miles per year, and that’s 750 miles per month.

As a reminder, here’s the monthly payments with the mileage:

Lease #1

Monthly Payment – $349/mo – 39 months – 12,000 miles per year, 1,000 miles per month.

Lease #2

Monthly Payment – $299/mo – 24 months – includes 9K miles per year or 750 per month!

So, for lease #1 that’s $0.35 per mile, $349 for 1,000 miles.

Lease #2 is slightly higher, it’s $0.40 per mile, $299 for 750 miles.

I’ve made these examples up, but they do have a realistic element to them, probably because I’ve seen a gazillion lease deals in my life!

When you compare the two leases, Lease #2 comes with a premium that’s normal because the depreciation is spread out over a shorter timeframe.

Now, if the idea of getting out of this car, into a newer one as quickly as possible appeals to you, then maybe you’re willing to pay that premium to hold the lease for only 24-months.

But, keep in mind, 750 miles per month is a VERY low number! That’s 25 miles a day in a 30 day month! And remember, whichever lease you choose, you should know the penalty for exceeding the total allotted miles.

At this point, I would respond to the dealer who’s provided you with Lease #2 and ask them for a monthly payment for 39 months, with 12,000 miles per year.

In this example I would also look at ALL the fees, and factor in any discrepancies. You might find one lease has a termination fee, the other doesn’t. If that’s the case, add the lease termination fee into the total payments, because you’re going to pay that like a last additional payment. You will also want to compare the Lease Origination fees, again including these to your total payments!

Now, I’ve shared a TON of information here!

Do you know how many people watch a car commercial and go, “WOW, a $99 a month lease, that’s GREAT!”

You now know they’re not well versed on how does leasing a car work!

Yeah, but that lease comes with either, $12,000 Cap Cost Reduction, or provides you with enough mileage to drive the car around the block once a month!

I think you’re able to see I really am an auto insider, and to gain even more insight into this process I strongly advise heading over and grabbing my New Car Buyer’s Course. It’s only $67.00, and you’re going to save WAY more than that price by getting a lower price, and save LOTS of time and aggravation!

I’ve got some great videos on the car buying process on my YouTube channel!

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