Leasing a car can be an attractive option if you drive reasonably low miles and enjoy upgrading your ride frequently. You can look forward to a new car every few years without dealing with large down payments and losing money on rapid depreciation. However, leasing can be more expensive than buying a car, and prohibitively so if you do not understand how leases work.
Understanding Auto Leases
Think of a lease as purchasing the right to drive the car for a set amount of time. Your payment covers the difference in the value of the car from the time you drive off the lot until you return it. Payments and terms are set around those values, along with a margin for the costs/profit set by the leasing company. It sounds simple, but industry jargon can make it difficult for you to keep track of these elements.
The initial value of the car is known as the capitalized cost. It is negotiated with the dealer, just as if you were buying the car. The value at the end of the lease is unknown, since the depreciation may not follow typical paths during the lease term or the condition of the car may decrease its value. However, an estimated value, known as a residual, is arrived at using typical depreciation trends and wear and tear.
Your payments are based on the difference in the capitalized cost and the residual — the amount of the car’s value that you “consume” — along with a multiplier called a money factor that represents the dealer’s overhead, costs, and profit margin. Money factors are typically given in decimal form and can be converted to an annual percentage rate (APR) by multiplying by 2400 and adding a percent sign. For example, a money factor of .00210 would translate to 5.04% APR. The rate you get may be influenced by your credit score. You can check your credit score and read your credit report for free within minutes using Credit Manager by MoneyTips.
To keep your monthly payment down, you need a lower capitalized cost, higher residual, and a lower money factor. Usually, you will be offered the means to lower your monthly payment through placing a down payment. By making a larger down payment, you lower monthly costs but assume more risk.
Consider that if you acquire an “adjusted capitalized cost” by making a significant down payment, you have lowered your monthly payment but given the same amount of money upfront to the leasing company. If the car is wrecked or stolen in the initial stages, you will not be reimbursed for the down payment and could be responsible for the full remaining value of the car — depending on what your insurance company pays. Gap insurance covers that difference as well as things like early termination fees, so make sure it is provided in your lease. If not, it is wise to consider getting your own.
A manufacturer-subsidized lease will generally be cheaper as it will include some combination of lower price, higher residual, or lower money factor to keep your monthly payments low. A higher residual value is fine, as long as the price is not raised to compensate.
Leasing companies usually base their lease on full retail price. Do your homework on the real value of vehicles through Edmunds or KBB, and negotiate the starting price down, making sure the lease company does not compensate by lowering the residual or raising the money factor. Look for dealer incentives that may reduce the dealer’s cost beyond the listed values.
Top Considerations for Leasing a Car
Here are a few other things to consider as you finalize your lease:
- Mileage Limits – Typical limits are around 15,000 miles annually. If your driving habits put you near the edge of that limit, make sure you check the overage costs. They can be prohibitive.
- Lease-End Condition – You may be required to make up a difference in the true and expected value of the car (deficiency) based on the condition, so make sure that the terms are understood. How large or deep of a scratch is considered normal wear-and-tear? What maintenance records are required to prove that oil changes and other basic maintenance steps were performed on the proper schedule? Make sure you document all potential areas of dispute. Consider getting a repair estimate so you can decide whether to pay for it on your own.
- Lease Terms – Typical lease terms are from two to four years. Set your terms as a matter of preference, but be aware that the longer lease periods increase the odds of mechanical breakdown or repair. Leasing past the warranty period is generally not a good idea, unless you are going for a much longer term and purchasing an extended warranty — and if you enjoy the car that much, why not just buy it?
- Fees – Check for additional fees such as drive-off fees (essentially a down payment), fees for early termination of the contract, penalties in case of late payment (default charges), dealer prep (getting the car ready for leasing) and any non-obvious fees applied to the vehicle at return. Thanks to the Consumer Leasing Act, leasing companies are required to disclose all fees (but they are not obligated to make it obvious). These fees are common, but look for excessive amounts.
Should you purchase the car at the end of the lease contract? Almost all lease contracts are closed-end, giving you the choice of whether to buy or not. Your decision should be based on your expected price (either the residual or the true market value), the terms you are offered at the end of the lease, and, of course, whether you had a great experience with the car. Economically, it will always be better to buy instead of leasing if you know that you are going to buy, but if you fall in love with a car, why not continue the relationship if the price is right?
Familiarize yourself with leasing jargon and the value of the car you are interested in, and you are likely to get the most out of your leasing experience.
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