How Does a Car Lease Work?

So, you need a car. Deciding between buying and leasing a car can be difficult. You may be asking yourself: how does a car lease work?

Leasing a car is like a long-term rental agreement. Leasing a car is a good option if you want a new car with the latest technology. A good lease can offer you low down payments and low monthly payments. You don’t own the car, but you’ll be able to return the car after a few years. You can then decide to get another lease on a new car with the latest technology.

Let’s take a closer look at how does a car lease work.

What Is a Car Lease?

How does a car lease work? When you lease a car, you have an agreement with the lessor (the company that buys and owns the car). You’ll generally have to make an upfront payment, plus monthly payments on the lease. You’ll be able to use the car for several years and at the end of the lease, you’ll return the vehicle. You can then decide if you want to start a new lease, purchase a car, or go carless.

When you lease a car, your monthly payment will be calculated based on the car’s depreciation, plus interest and fees. You are responsible for paying the depreciation between the purchase price of the car, and its value at the end of the lease.

Below are some details of a sample car lease:

• Duration: 36 months – 60 months
• Allowed Mileage: 15,000 miles per year
• Warranty: 36,000 miles or 3 years (whichever is earlier)
• Purchase Option: Yes

How does a car lease work in practice? Between you and the lessor, you determine the capitalized cost and the residual value. The capitalized cost is the price you are paying for the car. You should negotiate aggressively to get the capitalized cost as low as possible. The residual value is the price the lessor will pay to “buy back” the car at the end of the lease. The residual value is set by the manufacturer and you should confirm that the lessor is using the correct residual value.

In effect, you are “buying” the car and then “selling” it back to the lessor at a pre-specified price at a pre-specified time. However, car ownership doesn’t actually transfer to you – the lessor keeps ownership of the car at all times.

What Are the Benefits of Leasing a Car?

Leasing a car can be more appealing than buying for several reasons:

• Lower monthly payments – The monthly lease payments will generally be lower than the monthly loan payments for the same car.
• Smaller down payments – A car lease may require a smaller down payment than purchasing a car with a loan.
• New car with the latest technology – You may be able to afford a new car with the latest technology. If you always want to drive the latest-model car, a lease could be less expensive than buying and selling a vehicle every couple of years.
• Manufacturer’s warranty – Your car will generally be covered by a manufacturer’s warranty.

What Are the Disadvantages of Car Leasing?

Before you lease a car, however, you still need to consider the disadvantages of leasing the car. 

Leasing a car might not be best for your needs for several reasons:

• Long-term cost – In the long run, leasing will cost more than buying and holding on to a car.
• Paying depreciation upfront – You are paying for the depreciation at the beginning of the car’s life when it depreciates the most.
• Fees and penalties – What you can do with your car is limited. You may have a mile limit, or have to pay extra for wear and tear, or pay administrative fees.
• Termination fees – If you don’t need a car anymore, getting out of a lease can be expensive.
• Ownership of the car – You don’t own a car or have an asset once the lease ends. 

Leasing vs. Buying: What the Experts Say

Whether leasing or buying a car makes more sense depends on your personal situation.

Kevin O’Leary, O’Shares ETFs Chairman and “Mr. Wonderful” on Shark Tank, says the first thing you should do is “consider is how long you think you will have the car. The longer you plan to keep it, the more sense it makes to buy.”

For example, O’Leary recommends leasing a car if you’re going to want a new one in three years. If you’re going to keep a car long-term, for example, if you collect cars, then buying it makes more sense.

As explained above, leasing is also often cheaper than making payments on an auto loan, which is another factor to consider. Though you won’t be building up any equity in the car, like you would if you bought it, you can save some money for the time being.

What Credit Score Do You Need to Lease a Car?

Just like taking out a car loan, leasing may be easier and less expensive if you have good credit.

Generally, car leasing companies prefer customers who have a credit score of at least 700. Higher scores can help you qualify for a lower monthly payment.

Your credit score doesn’t affect the capitalized cost or residual payment. Your credit score does influence what is known as the money factor. The money factor is the rent charge on a car lease. It is similar to an interest rate on a car loan. The better your credit score, the more likely you are to get a good deal on the money factor of a car lease.

Some lessors offer leases on used vehicles, which may be easier to qualify for if you have bad credit. Or you can try to improve your credit before looking for a lease. Or consider purchasing a used car that’s a better match for your budget.

Considerations Before Leasing a Car

Once you’ve weighed up the advantages and disadvantages of leasing a car, there are a few final considerations you should take into account before signing the lease. 

Some lessors will charge an “acquisition fee” – an upfront fee for arranging the lease. Make sure you work this into your budget and cash flow.

Remember to negotiate your capitalized cost (sometimes referred to as cap cost) to get the best deal. These strategies are known as cap cost reductions.

There can also be a bunch of hidden costs included in a car lease. For example, you may have to pay a security deposit, a disposition fee, or purchase gap insurance. Make sure you understand all of the costs in your lease agreement and see if you can negotiate for some of the costs that don’t suit your needs to be removed.

Some lease agreements include a mileage allowance. A mileage allowance is how many miles you’re allowed to drive each year before the per-mile penalty begins. You can sometimes negotiate a higher mileage allowance.

The lessor defines normal wear and tear and how much you’ll have to pay if there is excessive wear and tear. If you smoke in the car, have kids or pets, or park on a busy street, you increase the chances of paying wear and tear penalties.

How to Lease a Car

If leasing a car sounds like the right option for you, here are some steps to take to prepare for your car lease:

1. Check your credit score to make sure you qualify to lease a new car. 
2. Determine how much you can afford to put down and how much you can afford to pay each month.
3. Make sure you know what your driving behaviour will be. Consider how many miles you drive and whether you are likely to incur wear and tear penalties.
4. Test drive different cars to find out which make and model you’d like to lease.
5. Shop around to see which dealership will offer you the best lease terms. You need to consider all of the factors that go into a car lease – the capitalized cost, the money factor, the monthly payment amount, the fees, the residual value, and the down payment. Make sure your lease offer performs well over all of the factors.
6. Sign the best lease offer. Be sure to read the entire agreement and make sure it reflects what was promised during the negotiations.

Auto Insurance and Car Leases

When you lease a car, you do not own the vehicle; instead, you’re paying for the use of the vehicle for a predetermined period and mileage. Just like when you finance a car purchase, the leasing company or the lessor retains ownership of the car. Here’s how car insurance works in relation to a car lease:

1. Required Coverage: Leasing companies typically require you to carry a higher level of car insurance coverage than the minimum required by your state. This often includes comprehensive and collision coverage, which pays for damage to the leased car.
2. Gap Insurance: Many lease agreements require gap insurance. This covers the difference between what you owe on the lease and the car’s value if the vehicle is totaled or stolen. Since cars depreciate quickly, the payout from a standard insurance policy may not cover what you still owe on the lease without gap insurance.
3. Liability Insurance: You must also have liability insurance, which covers damage to other vehicles and injuries to other people if you’re at fault in an accident.
4. Insurance Proof: You’ll need to provide proof of insurance to the leasing company before you can drive off the lot.
5. Premiums: Insurance premiums on leased vehicles may be higher than on financed or owned cars because the leasing company may require more coverage.
6. Insurance Claims: If you have an accident, you file a claim with your insurance company just as you would if the car were owned or financed. After paying your deductible, your insurance would cover the rest up to the policy limits.
7. Repairs: Any repairs must be completed with factory parts, due to the leasing company’s interest in maintaining the vehicle’s value.
8. End of Lease: When the lease ends, you return the vehicle to the leasing company. If the car has damage beyond normal wear and tear, you may be charged additional fees unless your insurance policy covers the repair costs.

When leasing a car, you must maintain a level of insurance coverage that satisfies the leasing company’s requirements, which is typically more than the state minimum and includes gap coverage. It’s important to factor in the cost of insurance when considering a car lease.

What Happens When You Get into an Accident When Leasing

When you get into an accident with a leased car, the process of dealing with insurance is similar to if you had an accident with a car you owned or financed, with a few specific considerations for the leased vehicle:

1. Notification: You must notify your insurance company and the leasing company of the accident as soon as possible.
2. Insurance Claims: You file a claim with your insurance company, which will assess the damage. You’ll be responsible for paying any deductible that applies.
3. Leasing Company’s Interest: The leasing company is the owner of the car, so they have a financial interest in it. Any check for repairs from the insurance company may be made out to both you and the leasing company, or directly to the repair facility.
4. Repair Standards: Repairs on a leased car must meet the leasing company’s standards, which usually means using original manufacturer’s parts and authorized repair shops.
5. Gap Insurance: If the car is totaled (meaning the cost to repair the car exceeds its current value), gap insurance can cover the difference between what the insurance pays out and what you owe on the lease. This is especially important early in the lease when depreciation outpaces your payment schedule.
6. Insurance Premiums: After an accident, your insurance premiums may increase upon renewal, depending on the nature of the accident and your insurer’s policies.
7. Lease Agreement Compliance: You need to ensure that the car is repaired in accordance with your lease agreement’s terms. Failure to properly repair the vehicle can result in additional fees or penalties when the car is returned at the end of the lease.
8. End of Lease: If the accident occurs close to the end of your lease term and the car is totaled, the insurance company’s payout (and gap insurance, if applicable) will go towards settling your account with the leasing company. If there’s damage and the car isn’t totaled, you’ll need to get it repaired before returning it to avoid end-of-lease charges.
9. Deductible and Remaining Lease Payments: Even if your car is totaled, you are still responsible for your deductible and potentially for any remaining lease payments until the insurance settlement is completed unless your insurance or gap coverage takes care of it.

It’s important to review your lease agreement and talk to your insurance agent to understand fully how your particular lease and insurance policy will handle an accident. They will be able to provide the most accurate information based on your circumstances.

Best Car Insurance for Your Lease

When selecting the best car insurance for a leased vehicle, it’s important to look for providers that offer comprehensive coverage options, including gap insurance, which is often required by leasing companies. Below are overviews of five insurance providers, including Allstate and Branch, that are known for their robust coverage options for leased cars:

Allstate

Allstate is one of the largest car insurance providers in the U.S., offering a wide range of coverage options that can be tailored to leased vehicles. They provide comprehensive and collision coverage, as well as gap insurance, which they term “Ride-Wise.” Customers leasing cars may also benefit from Allstate’s new car replacement coverage if their leased car is totaled. In addition, Allstate offers a variety of discounts that can help lower premiums.

Visit the Allstate website

Branch

Branch is a newer player in the insurance market, known for integrating technology to streamline the insurance process. They offer straightforward comprehensive and collision coverage, which is ideal for leased vehicles, and their policies can include gap insurance as well. Branch stands out for its easy-to-use online platform, allowing for quick policy management and claims filing.

Visit the Branch website

State Farm

As the largest provider of auto insurance in the U.S., State Farm offers a plethora of coverage options suitable for leased cars. Their policies can include gap insurance, often referred to as “Payoff Protector,” and they also offer accident forgiveness, which can be beneficial if you’re worried about rates going up after a claim. State Farm’s extensive network of agents can provide personalized service, which is a bonus for many customers.

Visit the State Farm website

Geico

Geico is well-known for its affordable coverage options and a multitude of discounts that can be applied to leased vehicles. They offer the full spectrum of standard coverages, including comprehensive and collision, and they provide a lease/loan payoff option, which functions like gap insurance. Geico’s user-friendly mobile app makes managing policies and filing claims straightforward.

Visit the Geico website

Progressive

Progressive offers competitive insurance options for those leasing vehicles. Their coverage includes standard comprehensive and collision, and they offer a loan/lease payoff coverage, similar to gap insurance, which can be particularly advantageous for lessees. Progressive is also known for its “Name Your Price” tool, which can help lessees find a policy that fits their budget.

Visit the Progressive website

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• How to Replace a Lost Drivers License in California
• Renting, Leasing, and Buying Cars for International Students

Final Thoughts

Congratulations! You can now answer the question “How does a car lease work?” and you are ready to go looking for a car lease.

Make sure you shop around for the best deal. You need to consider all of the factors that go into a car lease – the capitalized cost, the money factor, the monthly payment amount, the fees, the residual value, and the down payment.

Frank Gogol

I’m a firm believer that information is the key to financial freedom. On the Stilt Blog, I write about the complex topics — like finance, immigration, and technology — to help immigrants make the most of their lives in the U.S. Our content and brand have been featured in Forbes, TechCrunch, VentureBeat, and more.

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