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How Does Leasing a Car Work? Car Leasing Basics

How Does Leasing a Car Work? Car Leasing Basics
Kelly Boyer Sagert

Kelly Boyer Sagert

Updated November 1, 2021
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
If you’re thinking about leasing a vehicle for the first time, it’s natural to wonder how  leasing a car works.In this article, we’ll describe the leasing process, step by step, along with its pros and cons so you can decide if it makes sense for you. 

How Does Leasing a Car Work?

Leasing a vehicle resembles renting it for a predetermined time period, usually two to four years. You can typically negotiate and finance a lease through a dealership. Typically you’d pay a fairly small amount in taxes and fees to drive the vehicle off the lot. Then, you’d make monthly payments during the lease’s term. This may seem similar to car payments you make when you’ve bought a vehicle, but when you lease, you’re not building any equity or ownership. Plus, there are typically annual mileage restrictions and you’ll need to turn the vehicle back into the dealer in excellent shape to avoid paying additional fees. 

Leasing vs. Buying

According to Consumer Reports, more people are leasing cars in 2021 than a few years ago. That’s probably at least in part because the average price of a new vehicle is now more than $38,000 (with in-demand safety features only available on newer vehicles) and leasing offers lower monthly payments.At a high level, here are some differences between buying vs leasing a carWhen you're buying, you can either pay cash for a vehicle or take out a loan. If you're getting a loan, it’s common to make a down payment in cash and/or by trading in another vehicle. Each month, you then make a payment to the bank with some of it going toward car loan interest and the rest going toward principal. As the principal gets paid down, the loan amount goes down. When the loan is paid off, you fully own the vehicle. (It may be helpful to learn more about car loan amortization.)A lease is more like a long-term rental. You make a monthly payment in exchange for the ability to drive that vehicle during the agreed-upon term. When the lease term is up, you either need to return the vehicle or, if the lease permits it and you’d like to do so, you can buy it.

Car Leasing Terms to Know

Before you can understand car leasing basics, there are a few terms that are important to understand.  
  • Lessee: The person who leases the car
  • Lessor: The dealership that leases the car 
  • Acquisition fee: An upfront fee charged to the lessee for setting up the lease, typically ranging from $395 to $895. It can often be rolled into the monthly payment.
  • Buyout price: The cost of the vehicle if you want to buy it at the lease’s end
  • Capitalized cost (cap cost) reduction: Rebates, trade-ins, down payments, and anything else that decreases the amount financed in the car lease agreement
  • Closed-end lease: A lease agreement that doesn’t require you to buy the car at the end of the lease or to pay the difference between the market and residual value
  • Disposition fee: A fee charged by the lessor to clean and prepare the leased vehicle for resale after turned back in
  • Gross capitalized cost: Comparable to the vehicle’s selling price and sometimes called its “market value”
  • Mileage allowance: The number of miles the lessee can drive annually without penalty
  • Mileage fee or charge: The fee, typically assessed per mile, charged when the mileage allowance is exceeded 
  • Money factor: Comparable to an interest rate, it’s a figure that lessors use to calculate monthly payments 
  • Residual value: The projected value of the vehicle at the end of the lease 
If you don’t understand a term in your auto lease agreement, ask for help and/or do research to make sure you understand what you’re agreeing to.Recommended: Car Loan Terminology

Pros and Cons of Leasing a Car

Like every financial transaction, leasing a car involves both pros and cons.

Pros of Leasing a Car

People who decide to lease a car typically appreciate the lower monthly payments, as well as the upfront costs that are usually less than you’d pay with an outright purchase. Most repairs will be covered by the manufacturer’s warranty. When the lease is up (and the vehicle may need repairs more often), you can turn in the car without worrying about finding a buyer and lease another new car. Or, if you like the vehicle and want to keep it, many leases allow you to buy the car at the lease’s end.

Cons of Leasing a Car

Just as renting a home doesn’t allow you to build up equity in the property, when you lease a car, you don’t own it. At the end of the lease, your equity is still zero. Most leases have mileage restrictions, usually between 10,000 and 15,000 miles each year. If you exceed the annual limit, there’s usually a per-mile surcharge. You’ll need to pay for three types of auto insurance: comprehensive, collision, and gap. And, when your lease expires, you have no vehicle and likely will need either to buy that one or look for a different one to buy or lease.

Leasing a Car in 7 Steps

How does a car lease work? Here’s how to lease a vehicle in seven steps.
  1. Checking your credit score
  2. Setting your budget
  3. Calculating what mileage you need
  4. Choosing a make and model
  5. Looking for leasing deals
  6. Comparing lease offers from different dealers
  7. Signing the paperwork
Here are more details about each step.

1. Checking Your Credit Score

When you apply to lease a car, dealerships will check your credit scores. In general, a FICO® score of at least 700 is preferable and can help the lessee get a lower monthly payment. If your credit score is less than desirable, options you might consider include a lease on a used vehicle, which may have guidelines that are less strict. Another option could be to focus on strengthening your credit history for a while before leasing.

2. Setting Your Budget

In general, experts recommend that you spend somewhere between 10% and 15% of your after-tax income on car expenses, which would include the lease payment, car insurance, and gas. What’s most important is to calculate what you can afford and then stick to that dollar amount. 

Trading in a Car for a Lease

If you’re trading in your current vehicle to obtain the lease, the dealer will offer you a dollar amount for it. When there’s an outstanding loan on the vehicle, they will often take care of the nuts and bolts of paying it off, subtract that from their trade-in offer, and then take that amount off the lease costs. This can streamline things for you because the dealer typically handles the paperwork for these multiple transactions. Plus, in many states, this can save you money on sales tax since the amount (in those states) is only charged on the lease price after the trade-in amount is deducted.This can even happen with upside down auto loans (when you owe more than the vehicle is worth) although they can be more complicated. In those cases, it may make sense to consider the possibility of someone else taking over your auto loan. If it’s financially feasible, you could also explore paying off your car loan faster and getting out of the upside down scenario.

3. Calculating What Mileage You Need

Let’s say that you’re offered mileage options of 10,000, 12,000, and 15,000 for each year of the lease term. How can you pick the one that allows you to avoid overpaying?When it comes to mileage, the past might be a good predictor of the future—or can at least be a reasonable starting point. How many miles have you been driving to work and/or school each week? What about running typical errands? If you take a weekly estimate and multiply it by 52, that can give you a good baseline. It may also help to factor in any car trips or vacations you take during the course of a year. Add in that mileage, too, and look at the total and then round up to the next mileage option. 

4. Choosing a Make and Model

You’ll want to lease a vehicle that meets your personal and professional needs. Someone who spends lots of time transporting kids to sporting events will, for example, need something different from someone who picks up potential clients from the airport. You’ll also want to consider which vehicles depreciate the most quickly. 

5. Looking for Leasing Deals

It makes sense to contact multiple dealerships to see what deals they have for people who are leasing a vehicle. Read the fine print, including mileage allowances, fees charged, the money factor, whether the lease is open or closed, the residual value, and the other details of the contract. Make sure you understand the terms, and if you don’t, enlist help you can trust. 

6. Comparing Leasing Offers From Different Dealers

After gathering information from multiple dealerships, compare the different offers to see what deal might be best for you—and don’t be afraid to negotiate. For example, you can negotiate to get the capitalized cost, also known as the cap cost, as low as possible. But if you succeed in bargaining it down, watch to make sure the dealer doesn’t add on other fees or extend the lease period (which wouldn’t benefit you because it adds to the number of payments). You can also negotiate the mileage allowance, the fees, the residual value, and more. The dealer doesn’t have to agree with what you propose, but it can often be worthwhile to try.

7. Signing the Paperwork

Finally, the red letter day arrives and it’s time to sign your car lease agreement. When you sign, make sure that you understand every element of the agreement and that it matches what you negotiated. 

What Happens at the End of a Car Lease?

When the lease ends, you can turn in the vehicle, pay any fees (such as mileage charges, disposition fees, and any fees for vehicle damage) and be done with the deal. Or you can turn the car in and start the leasing process all over again with a different vehicle. Or, if your lease permits and you’d like to buy the car, you refinance it. The price will be listed in the auto lease agreement, and you can then shop around for the best lease buyout refinancing deal. 

Find Personalized Auto Loan Refinancing Rates from Lantern

Shopping for a car loan to refinance your leased vehicle?With Lantern by SoFi, you can fill out one simple application to get prequalified and to receive competitive offers from our network of partners. Then you can quickly and easily refinance your car loan online. There may even be options if you're refinancing an auto loan with bad credit

The Takeaway

Leasing a car is similar to renting it for a period of two to four years. If you decide to lease, it’s important to understand car lease terms as you navigate the seven key steps of the process. At the end, you can turn in the vehicle, turn it in and get another lease or, if the lease permits, you can choose to refinance the vehicle, thereby buying the car.
Photo credit: iStock/Prostock-Studio
The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.SOLC0921172

About the Author

Kelly Boyer Sagert

Kelly Boyer Sagert

Kelly Boyer Sagert is an Emmy Award-nominated writer with decades of professional writing experience. As she was getting her writing career off the ground, she spent several years working at a savings and loan institution, working in the following departments: savings, loans, IRAs, and auditing. She has published thousands of pieces online and in print.
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