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How leasing a car works... and is it better than buying?

At a glance:

To buy or to lease? That's one of the existential questions that drivers ponder.

Some drivers swear by it, others swear against it. Leasing isn't just a matter of plopping down some rent every month in return for the use of a nice car — you also have responsibilities, which can cost you big money if you're not careful.

Auto leasing has grown greatly in popularity as an alternative to owning. Price is perhaps the main factor driving the popularity of leasing. New car costs have risen greatly, and other costs such as healthcare and housing have risen greatly, putting a damper on people's ability to buy new vehicles.

Enter leasing. Around one fifth of new vehicles are leased rather than bought outright. Let's look at the pros and cons of leasing so you can determine whether it's a good choice for you.

How car leasing works

Leasing simply means paying for the use of a vehicle over a specific period of time. In this respect, it is similar to renting. Beyond that, there are many differences, so the comparison to renting is not an accurate one.

The price of a lease is based on the depreciation of the vehicle and the interest cost.

How it works

When you sign a lease, you agree to make regular monthly payments on it, maintain it, pay taxes on it (including sales tax), pay license fees, and buy insurance for it. As part of the lease, you agree to keep the vehicle for a certain number of months (the maximum is usually 48 months) and then turn it in at lease end. With many leases, you have the option of buying the vehicle at the lease's end.

When your lease ends, you must turn the vehicle back in to the leasing company with no more than expected wear and tear, and within the mileage limit specified in the contract. If you go over this limit, you must pay a fee. If there is damage, you must pay for that.

Your options

As noted, you may have the option to buy the vehicle at this point for a price. You may also have the option to trade it in for another lease. You might even have the option to extend the lease. If you decide to turn it in once and for all, you may, at some leasing companies, need to pay a disposition fee.

What is residual value?

The leasing company estimates the car's residual value at the end of the lease, it bases this on the expected number of miles driven. Should the vehicle's actual market value be worth more than the residual value at the end of the lease, you might just want to buy it and either keep driving it or sell it for a profit.

Generally, the longer the lease, the lower the residual value will be. But it is worth checking the value of the vehicle with a pricing site such as the Kelley Blue Book. You may find that you can recover some equity by buying it.

It is important to read the lease contract carefully to determine what you are responsible for. Failing to do so can cost you a lot of money.

A word about insurance

Although you are leasing rather than buying, you still must maintain auto insurance on your car. The coverage may be more or less than you would normally buy. The price varies by company, but a typical contract might require $100,000 of liability per person and $300,000 per occurrence and $50,000 for property damage, and both comprehensive and collision.

As with any form of insurance, it pays to shop around before you buy and to look into all available discounts that insurance companies offer.

Getting a good deal on a lease

To one who is new to leasing, a lease might seem like a good deal if the monthly payments are lower than they would be if the person bought the car instead.

But a low monthly payment isn't necessarily the sign of a great deal.

A low payment might be low because some other factor such as the lease-end residual value of the car was set in a way that is profitable to the leasing company but not to you.

The price of the vehicle

Newbies to the leasing scene don't always think about the price of the vehicle they want to lease. It may not be obvious at first, but you can negotiate the price of a vehicle you want to lease. It's not set in stone.

When it comes to negotiating, leasing companies would prefer to work from the MSRP (manufacturer's suggested retail price) because it is more profitable to them. Savvy negotiators look at the invoice price instead and negotiate upward from there.

The lease rate

Leased vehicles have a lease rate (also called a money factor). This is a rate that is based on the interest rate that the leasing company pays to the dealer on its own loan for the vehicle. Lease rates are not required to be disclosed to consumers, so you may not even get to see what it is.

Lease rates can change just as frequently as rates for new-car loans. Lease rates will also depend on your credit score. If your credit score is high, you can qualify for a low rate. The most favorable lease rates are those offered by finance companies that are associated with the major auto companies. Such finance companies are known as "captive" finance companies.

Some finance companies will lower your lease rate if you put down a larger down payment at the beginning of the lease.

Special lease deals

Auto manufacturers sometimes offer lease deals through their captive finance companies. These are traditionally very favorable to consumers. Monthly payments can be low, and residual value can be high. Note that good deals like these may come with restrictions that you will have to agree to.

Shopping around

Car pricing services work with you to find the best deals. You tell them what you are looking for and they shop your area for the best prices. CarsDirect and Edmunds are two well-known companies that offer car pricing services.

Sales and leasing consultant Ernie Alvinito looks out a window as he awaits a customer. (Photo: Tim Boyle/Getty Images)
Sales and leasing consultant Ernie Alvinito looks out a window as he awaits a customer. (Photo: Tim Boyle/Getty Images)

Taking over a lease

Have you considered taking over an existing lease? You may get a deal with no money down and possibly low monthly payments. There is a transfer fee to acquire the lease, but once you pay it, the car is yours to drive for the remainder of the lease.

Other factors to consider

Look at all upfront payments you will need to pay, such as the acquisition fee. Look at the mileage allowed per year and the required charges for excess mileage incurred. Note the early termination fees, the option to buy, the length of the lease, the gap insurance, and of course, the monthly payment.

Ask about …

Finally, ask about rebates, advertised specials, factory-to-dealer incentives, or other discounts that would reduce the price of the vehicle.

Advantages and disadvantages of leasing a vehicle

Those who like to lease can point out the advantages quickly enough, and those who don't like leasing can point out the disadvantages pretty fast. Here are both the pros and the cons.

The advantages

  • The convenience of turning in the car at lease's end rather than having to sell it or trade it in.

  • You can usually pay less with leasing, though this depends on several factors. Generally, you pay for the portion of the vehicle that you will actually use in time, rather than the whole thing.

  • There is usually little or no down payment required.

  • The sales taxes you pay on your monthly payments are tax deductible in most states.

  • Sales taxes are spread out, since they are levied on the monthly payments, rather than being paid all at once up front.

  • You can negotiate the value of the car.

  • Most leases come with gap insurance included. Gap insurance pays off the difference between what you owe on the lease and what the car is worth in the event that it is totaled.

The disadvantages

Before you sign on the dotted line, consider these disadvantages:

  • You may be required to pay more for insurance on the vehicle than you would pay on a car you bought.

  • If you are a perpetual leaser, you will be stuck with car payments that never end.

  • You will be penalized if you exceed the yearly mileage limit. This limit is usually 10,000-15000 miles and varies according to company. The penalty will be 18–25 cents per mile or thereabouts. Do you drive a lot? Consider that.

  • If you buy the car when the lease ends, you'll pay more than if you had bought the car outright.

  • Breaking a lease early results in a big termination fee. (On the bright side, you can transfer your lease to another person: there are now Websites devoted to that service.)

  • You will have no equity in the vehicle. The only time you could have any equity is when the market value of the car at lease's end is higher than the price you would have to pay at lease's end to buy it (the purchase option price). You would have to buy it to get this equity.

  • If there is damage or excessive wear and tear, you will have to pay to have those repaired. Lease contracts typically define what "excessive" means.

How to decide whether to buy or lease a car

For most people, the answer to this question will come down to dollars and cents. To those for whom money isn't as much of an issue, there are other things to ponder.

A list of advantages and disadvantages can help you determine whether to buy or lease. For those who are still on the fence, here are some more things to think about:

How do you treat your cars?

Want to repaint, customize, or add racing stripes? Then expect to have them undone, and then expect a bill in the mail. The car doesn't belong to you while you lease it, so you can't make changes to it.

Are you tough on your cars? Or irresponsible? You will be responsible for any damages and any wear and tear that is deemed excessive. Leasing does not let you off the hook for these.

Are your finances stable?

Your financial situation should be stable if you want to lease, because you will be committed to your auto. Ending your lease early will cost you extra, and you may also have to pay all the remaining payments.

Ask yourself whether you might be hit soon with high healthcare costs, mortgage costs, or other expenses that could jeopardize your ability to make your lease payments.

How much do you drive in a year?

Estimate how much you drive in a year. Is it more than the amount specified in a lease, meaning between 10,000 and 15,000 miles? If it is, you'll be hit with excess mileage charges when the lease ends. Can you reduce your mileage in other ways, such as by biking, walking, or bussing? If not, consider those excess mileage costs and whether they would be a hassle for you.

How is your credit?

You need a very good credit rating in order to lease. One reason for this is that the leasing company bears a lot of risk when it offers you the lower monthly payments. If your credit is poor, you may pay a higher lease rate (which is factored into your monthly payments). Do you know your credit score?

How do you really feel about leasing and buying?

Some people just like to own, so buying appeals more to them. They can build up some equity, which owning allows them. Leasing doesn't build you equity — at least not until you decide to buy at the lease end, if you do at all. Another plus for buyers is that eventually, they can stop making payments and own the car outright.

On the other hand, some people would rather not have any ownership. It is the convenience factor that they like and are willing to pay for. That convenience includes a lower chance of needing repairs and a high likelihood of having warranty coverage for the duration of the lease.

Summary of car leasing

Leasing a car can be a good choice for those looking to save on costs. It can work for you if you can stay within the limits of the leasing agreement.

If you lead a stable life and take good care of your cars, you may find leasing an advantage. If you are more unpredictable with your car needs, it may not be the best option for you.

The Federal Trade Commission has additional information for would-be leasers at www.consumer.ftc.gov/.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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