How Does a Car Lease Work?

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Should you lease a new carWhen it comes to getting a care to drive, the debate usually focuses on buying new or buying used. In most personal finances circles, the idea of leasing a car is repugnant. However, when I read the Four Hour Workweek a few years ago, I surprised to see that Tim Ferriss considered leasing a car an option, since it can provide you with the car you want for your lifestyle cost.

Since then, I have seen a few other posts and articles in favor of leasing a car. Generally, you can lease a car for less per month than buying. Plus, after three years or so, you can turn in the car without having to worry about selling and get a new car. While I’m happy with buying cars and driving them into the ground, I can see why those who like to regularly “upgrade” to a new car might want to lease.

But how does a car lease work? Essentially, you are renting your car instead of buying it.

The Basics of the Car Lease

When you lease a car, you basically pay for its depreciation. We’ve all heard about the loss of value when you drive a new car off the lot. When you lease, you pay for the depreciation by financing the difference between what the car costs now, and what it is expected to be worth by the end of the lease (typically three years). So, if the new car is $25,000, and it will be worth $15,000 in three years, you will need to finance $10,000 for those three years.

If you want a similar monthly payment when you buy the $25,000 car and make payments over the course of three years, you would need a $15,000 down payment. Or, you could pay a higher amount each month, financing a larger portion of the $25,000. You could also draw out the loan term. Financing on a new car can usually be stretched out for 60 to 72 months. In that case, though, your interest charges start to add up.

There are other things to consider about the car lease, though. First of all, you need to know the mileage limits. Many car leases limit you to 10,000, 12,000, or 15,000 miles per year. If you want more miles, you can pay for them up front, increasing how much your car lease costs. If you don’t pay for extra miles for the year, you will need to pay for them at the end of the lease. Generally, though, extra miles cost less if you “purchase” them beforehand, rather than paying for them as a penalty at the end of the lease.

In some cases, you might have to pay an extra amount at lease signing. Make sure you understand the terms. In some cases, you have to make a larger lump sum payment at the beginning or the end of the lease, in addition to your monthly payment. Also be aware of penalties that might be assessed for damage to the car during your lease period. You will need to drive carefully, and make sure that all of the required maintenance for the car is completed while you have the leased car.

For those who like getting new cars regularly, and don’t want the hassle of selling an older car, leasing can be a reasonable option. However, it’s important to be careful, and pay attention to realities of leasing.

(Photo: NRMA New Cars)

{ 12 comments, please add your thoughts now! }

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12 Responses to “How Does a Car Lease Work?”

  1. Frugal says:

    Generally, leasing is better than renting if you are going to keep the car for 2-3 years. If you plan to keep the car for longer period, say 5-7 years or more, it pays to buy one and maintain it. In long run, you will be ahead as long as you maintain your car.

  2. Seth says:

    As you said, leasing is really only a decent option *if* you have that need for a new car every couple of years.

    There is a reason that car lots advertise and push the lease options…

    I worked at a dealership back in my college days. Even then, I was a firm believer in the power of buying pre-owned vehicles, maintaining them, and driving them for many, many years. During the new employee training, I gave the instructor a pretty hard time when he was teaching us how to show the customers that leasing was s “great deal”.

  3. Bill says:

    Did anybody proof read this? When it comes to getting a “care” to drive? In most “personal finances” circles?

  4. Dragonflower says:

    IMHO leasing is only an option if a person has a job where driving a recent model vehicle is an expectation (e.g. salesman, executive, etc.) One can get a new car every 3 years and just walk away from the responsibilities of ownership.

    Leasing is not unlike buying a car, and then wanting to trade it in before you have made all of the monthly payments. You are going to lose money on the deal.

    However, after doing all of the research, I still think the BEST deal is to buy a slightly used vehicle (12-18 months old) with low mileage, maintain it well, and then drive it into the ground. If you live out in the Boonies in the snow belt, get yourself a sturdy used SUV.

  5. John says:

    Rarely mentioned in the Lease vs. Buying argument is the additional “Risk” premium charged to the lease’ee. In the example in the story, the $15,000 residual value of the car after three years is really just a guess on the lease’ors part. So to protect themselves they will typically guess low and thereby increasing the cost of the lease. So generally overall leasing is a more costly option than buying – even if you trade cars every three years. On the other hand the economic slowdown/collapse caught many lease’ors by surprise (lots of trucks and big cars just weren’t worth as much in 2009 than estimated in 06) giving a windfall to the lease’ees.

  6. Judith says:

    If you can pay cash for the car AND maintain it right AND drive it into the ground, that’s gotta be the cheapest option. We don’t pay a penny of interest.

    • Wilson says:

      In essence, you are paying interest because you could otherwise be investing the money in something else. It might be wiser to have a longer car loan at a lower rate and put that money into a mortgage and you would net the different of the mortgage vs car rate.

  7. Srinivas says:

    I bought a used car with 60K miles 8 years back and drive around 10K miles per year. I can use my car for another 10 years. I change the oil twice a year and completed my 100M service. Apart from this I did not spend a single penny on maintenance so far. I have a base min insurance.

  8. Fried says:

    We leased a car last year for a 3 year term. We want to go Hybrid but did not see anything that got us excited. We figured in 3 years we’ll have more choices. Leasing seemed like an easy way to get to where we eventually want to be. But I guess the fact that my wife uses the car for work and we get a fat tax break helps a bunch.

  9. Dan says:

    I have to chine in about car leasing. I have been a party to many leases and i would never lease a car unless you are prepared to pay an average extra $500-1000 or more at turn in.
    Most leases end in 24-36 months and the car companies have turned the lease turn in details to one of 3 major independent companies. These companies get a portion of the proceeds that are collected at turn in so you will ALWAYS be charged an extra amount unless your car looks like you never drove it. . In addition , the tires, brakes , and other wear items are usually at their replacement times and guess who is responsible?In a very limited number of leases there is $1000 forgiveness so those may be o.k. but otherwise just be aware of this big scam that is being perpetrated on unsuspecting consumers.

  10. Tom says:

    In the example cited, the lessee pays interest on the entire $25000, not just on the $10000 depreciation. Leases make the most sense for those who write off their vehicles for business.

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