How to Lease a Car

Leasing a car isn't right for everyone. It is most beneficial to those who claim their car or truck as a business expense. Nearly all leasing expenses attributed to business purposes can be deducted. If you can deduct vehicle costs for business, consult a tax advisor to find out which is better for you. Nothing is perfect, and leasing does have pitfalls. Unlike an outright purchase, you'll have no equity in the vehicle at the end of the payment period. This virtually guarantees that you'll be buying or leasing another vehicle once the lease is up. For consumers who are content with leasing, of course, that's a benefit rather than an obstacle.

Also, leases come with strict mileage limitations, usually 12,000 to 15,000 miles per year. If you exceed the total allowed miles by the time you return the vehicle, you'll be assessed a penalty -- which could be as stiff as 25 cents per mile. However, if you know or suspect that you'll be putting on additional miles, you can usually purchase extra miles in advance at a discounted rate.

If you tend to be hard on your vehicles, purchasing is probably a better way to go. Why? Leased vehicles must be returned in excellent condition, without dents, deep scratches, window cracks, or torn upholstery, and with all accessories in working order. Otherwise, you'll be assessed "excessive wear and tear" fees at the end of the lease period, and these can be steep.

If you're uncertain about your financial future, leasing might not be right for you, either. Once you enter into a lease, it's binding for the entire length of the agreement. Terminating the agreement is nearly always difficult and expensive. If you decide you want to get out of a lease in order to lease another vehicle, you might be able to have the first lease "bought out" as part of the deal. If you simply want out, you will probably be assessed a hefty termination fee designed to keep people from trying to break their leases.

Leasing a Car vs. Buying a Car

Here is an example of how the costs of leasing and buying a vehicle break down:

In this example, we compare the cost of purchasing a 2006 Honda Pilot EX AWD with a 36-month loan at 6.75 percent to what it costs to lease the same vehicle for 36 months. Lease specifics are based on a Honda-underwritten contract as advertised in the Chicago area during the month of July 2006. This example does not include taxes and licensing fees, which vary by region. Trade-in values were provided by Edmunds.

Purchase Price:

Lease = $33,595

Purchase = $33,595

Advantage: None. Leasing doesn't change the fact that a vehicle is being purchased. Just like buying a car, the actual price of the car can, and should, be negotiated. For simplicity's sake, our example, Honda Pilot, will sell for retail price. This is not far from real market conditions.

Down Payment:

Lease = $2,000

Purchase = $6,719 (20 percent)

Advantage: Lease. If you can't come up with the down payment, leasing looks pretty good right now. Getting the best interest rate on a new-car loan usually means coming up with 20 percent of the purchase price as a down payment. Of course, many new car buyers have a trade-in to offset this expense, something a repeat lessee would not have. Note that in this example the lease down payment includes the first month's payment.

Monthly Payment:

Lease = $359

Purchase = $825

Advantage: Lease. Leasing looks really good now. Paying for only a fraction of a vehicle has its advantages. Don't forget, this example is based on a 36-month lease versus a 36-month loan. Many shoppers will opt for 48-, or 60-month loans to reduce their payments, though this will increase total costs because of the interest. However, a direct comparison with a longer loan is difficult, as leases greater than 36 months are rarely available.

Total Spent After 36 Months:

Lease = $14,565

Purchase = $36,419

Advantage: Lease. If keeping money in your wallet is your primary goal, so far this lease is working for you. The buyer is out two and half times as much money as the lessee.

Residual Value of Vehicle: 

Lease = $0

Purchase = $23,701

Advantage: Purchase. You probably saw this coming. As a lessee, you were merely renting a car. The buyer, though taxed by higher monthly payments, now has some serious equity in the vehicle. This is money that can be used as a down payment on another new vehicle.

Real Cost:

Lease = $14,565

Purchase = $12,718

Advantage: Purchase. Here's the real bottom line. The lease would have saved you a lot of up-front cost, but counting the value of the vehicle, our purchaser is now almost $2,000 ahead.

Before you lease a car, there are several important things you need to know. We'll reveal these details in the next section.

The basic allure of leasing a car is that you don't have to pay for or finance the entire cost of a vehicle. You're simply paying for the use of that vehicle for a specific period, often two or three years or as long as five or six years. It's not exactly renting, but the principle is similar. Evaluating a lease is a matter of basic arithmetic. You need to consider four factors:

With a lease, your monthly payment is based on the difference between the vehicle's transaction price (its "capitalized cost") and what it's estimated to be worth at the end of the lease term (the "residual value"). This difference is financed at a particular rate of interest (which may be called a "lease rate," "lease charge," or "money factor").

Typically, your down payment and monthly charges will be lower with a leased vehicle than one purchased outright. That's why you can usually obtain a better vehicle for the same cash you put down. You might need nothing more to secure a lease than the first month's payment and a security deposit, which is usually about one monthly payment. Details vary sharply, though. Many lease deals require a substantial down payment and possible additional charges.

Nothing affects lease terms more than your credit score. The alluring terms seen on TV commercials are available only to customers with a top-notch credit history. So-so credit means a bigger down payment and/or higher monthly payments. Poor credit generally means no lease at all.

In any case, when the lease period is up, you simply return the vehicle to a dealer without having to worry about a trade-in or selling it to a private party. Provided that the vehicle is returned in good condition, you owe nothing more; but you own nothing, either. Most leases give you the option of purchasing the vehicle at the end of the contract at a predetermined price. If you really like the car, that's a possibility. However, this is often more expensive over time than buying it outright.

How To Shop Around for a Car Lease

Just as it pays to shop when you're buying a car, it's also wise to shop around for a lease. Make a few dealers compete for your business. One dealer might waive the down payment or cut the monthly payment to win your business. Others won't budge.

Make sure you compare costs for identical vehicles. A lease with low monthly payments and a hefty down payment might cost more overall than one with higher monthly payments but no money down. Do the math, and consider the total amount that you'll be paying -- both now and over the lease term.

Naturally, new-car dealers are a logical place to start your shopping, but there are alternatives. Leasing agents or brokers that lease several brands might beat the deal from the new-car franchise down the street. Some banks and credit unions also offer consumer leases.

If you lease from a dealer who uses an in-house finance company like Ford Credit or GMAC, at the end of the lease you generally can leave the car with any dealer who sells the same brand. This may not be the case if you lease from an agent or broker, or if a dealer uses an independent leasing company. Be sure to ask -- just to be prepared.

You'll also want to be prepared when it comes time to negotiate the lease. We'll provide some pointers on the next page.

Keep in mind that when you lease a vehicle, just as when you buy one, its cost is negotiable and based on a variety of factors. The lower the total price, the lower your lease payments will be. To keep costs down, choose a model that has a higher resale value. Consult a used-car pricing guide to see how well a vehicle's value has held up historically, or ask the loan department of your bank or a leasing company to compare new vehicles' residual values.

Many libraries carry the "Residual Percentage Guide" issued monthly by "Automotive Lease Guide." Charts estimate how much each vehicle will be worth after a specified period of months as a percentage of the car's original selling price. This gives a clear picture of which vehicles hold their value best and are therefore prime candidates for leasing. Avoid those with low residual value, because lease terms are certain to be more costly. If a manufacturer is trying to promote a specific model, its lease terms might be even more favorable.

A few years back, manufacturers were subventing leases, absorbing part of the cost by setting artificially high residual values in an attempt to get more vehicles into shoppers' hands. This tactic resulted in substantial financial losses, so automakers nowadays are more wary about residuals and subvention of this sort is less common. However, advertising campaigns often stress the lowest-cost lease deals, some of which are based on tempting interest rates.

Understanding the Fine Print of a Car Lease

Before you sign the lease, make sure that you read and understand everything on the page. Federal regulations require certain facts to be disclosed on lease agreements, including the capitalized cost, interest rate, up-front fees and taxes, any credit provided for used-car trade-ins, the vehicle's residual value and the amount to be depreciated. Most leases contain an acquisition fee, which typically ranges from $250 to $450, and a disposition fee, which likely adds another $300 or $400. A contract may also include a purchase-option fee that allows you to buy the vehicle at the end of the lease for a predetermined price.

Look for a detailed description in the contract of what constitutes "excessive wear and tear," and some indication of what you could be charged for this at the end of the term.

If it's not already included in the lease package, you will be offered "gap insurance" (guaranteed asset protection). This covers the remainder of your lease payments if your leased car is stolen or totaled in a wreck. Even if it's not required, some lessees feel more comfortable if they have a "gap" policy in effect.

Most leases prohibit customizing vehicles with aftermarket accessories such as vinyl tops, exterior trim, and even trailer hitches. Ask before you install such items. The consumer typically pays for sales tax, annual vehicle registration fees and taxes, maintenance, and insurance. All of this should be spelled out in the contract, but find out which portions will be included in your monthly payments and which ones you'll have to pay separately. Some states and municipalities permit dealers to charge specific extra fees, which may not be negotiable. All others can be challenged.

In the final section, you'll find a glossary that will come in handy if you're thinking of leasing a car.

Before you hit the dealerships, arm yourself with the tools you need to understand car leasing. Below are common car-leasing terms and their definitions.

Acquisition Fee: A charge for processing a lease. Even though this seems like a nonessential fee, it may not be negotiable.

Capitalization cost (cap cost): The total price of the vehicle, which the lessor uses to calculate the amount that the customer will be paying. This is equivalent to the purchase price of a vehicle that's sold.

Cap Cost Reduction: Equivalent to a down payment on a purchased vehicle, this is the amount that you pay when signing the lease, in addition to any separate fees that are assessed. When you pay a larger sum initially, monthly payments will be lower. A smaller cap cost reduction means a higher monthly payment. The value of your trade-in (if any) can be applied as part of this amount.

Closed-End Lease: A lease that fixed the vehicle's residual value initially, stating it in the contract. Most vehicle leases are closed-end, which means the customer won't owe an additional sum at the end of the term if the car turns out to be worth less than anticipated.

Dealer Participation: An amount that the dealer contributes to lower the total price of the vehicle, in an attempt to secure the customer's business. Any dealer contribution is applied to the cap cost reduction.

Depreciation: The amount by which a vehicle loses its value over a specified period of time, which is the difference between its original price and its residual value later. No specific figure for depreciation appears in lease contracts, but it's taken into account in setting residual values.

Disposition Fee: An amount to be paid at the end of the lease term, to cover costs of preparing the returned vehicle for sale.

Early Termination Fee: A penalty assessed if you choose to end the contract earlier. Lessors justify this because depreciation is highest in the early portion of a vehicle's life, so a prematurely terminated lease cuts heavily into their earnings. The penalty is likely to be hefty.

End-of-Lease Purchase Price: An agreed-upon price that you will pay when the lease is up, if you choose to keep the vehicle.

Excess Mileage Charge: A per-mile amount charged if you drive the vehicle more than the stated maximum, which is typically 12,000 to 15,000 miles per year. A charge of 15 cents per additional mile is typical, but it could be higher. If you expect to drive farther than the contract allows, you can usually negotiate a lower figure for the excess miles.

Excess Wear-and-Tear: If the vehicle is returned in good condition, there should be no extra charge. A certain amount of wear-and-tear is permitted, but significant body damage or evidence of improper maintenance will trigger additional sums to be paid for necessary repairs.

Gap Insurance: In most cases, your regular auto insurance covers the leased vehicle. If the vehicle is totally wrecked, however, it could be worth less than an insurer will pay. Gap insurance covers the difference between the cash value of the vehicle and what you still owe on the lease contract. Some leases include this in the contract.

Lease Term: A period of months during which you have use of the vehicle and will pay an agreed-upon monthly payment. Lease terms of 24 or 36 months are most common, but 12-month leases or 60-month contracts can be obtained.

Lessee: The person who leases a vehicle from a dealer or other organization.

Lessor: The dealer or other organization that leases a vehicle to a customer.

Monthly Payment: Amount that you are required to pay to the lessor or its agent every month, through the lease term.

Purchase Option: The right to buy the vehicle that you've leased, at the end of the lease term, for a stated price.

Residual Value: A prediction of what a vehicle is likely to be worth as it ages, usually expressed as a percentage of its original price. Residual values may be supplied for vehicles that are 24, 36, or 48 months old.

Security Deposit: A deposit, usually refundable, required before the lease contract takes effect.

Subvented Lease: A lease with favorable terms, due to a manufacturer's decision to absorb a portion of the cost. The manufacturer "subsidizes" part of the total price, by use of a special incentive -- a low interest rate, higher-than-normal residual value, or a discount provided by the manufacturer.

Now that you know about the particulars of leasing a car, you're ready to decide if it's the right choice for you.