Car Leasing Explained
Simply put, leasing is a long-term rental. With few exceptions, you can only lease a brand new, model-year vehicle—no used, certified, or leftover new cars from last year's inventory. (The exceptions are some exotic brands with which some lenders will finance a lease, but it’s more expensive than leasing a new car, and you have to buy the car at the end in most cases.)
The person who leases is generally looking for one or more of the following benefits:
- Leases generally have lower payments.
- They get a brand-new vehicle with the newest style and technology.
- The vehicle is protected by a factory warranty.
- Leasing eliminates some negative equity.
Some of these are very important to people, and it is important to remember that everyone is motivated differently. We are driven by the experiences we have had and the lessons we learned from them.
For these reasons and more, leasing can be a very attractive option for many new car shoppers.
This will get a little hairy for a minute but stay with me and you will understand.
When you lease a car you are basically renting it for two, three or four years. What you will pay during that time is determined by the vehicle's residual value, or what it will be worth when your time is up. So you are basically paying for your time in it.
For the sake of simplicity let's say the vehicle costs $50,000 and is determined to have a residual value of 50%, which means the car will retain 50% of its value at the end of your lease. You will pay the lost value, or $25,000, over your lease term and the car will be worth approximately $25,000 when you turn it in. (Forget about taxes, dealer fees, finance rates, etc., and just look at the price of the car to understand leasing.)
To recap in basic form:
Total cost: $50,000
Residual value: $25,000 (50%)
Your obligation: $25,000
Let's say you choose to lease for 48 months, the longest that is usually offered. You will divide the $25k by 48 months to determine your monthly payment.
Your Payment: $25,000 / 48 = $520.83
Now remember that this number will change when you add taxes, fees, and any additional mileage allowance, then minus any down payment you apply to the purchase. If you have a vehicle to trade in and you have value there, you subtract that also. If you owe more than your car is worth, I will discuss negative equity further down in this article.
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Lower Monthly Payments
Yes, lease payments are usually cheaper than the payment would be if you bought the car.
Simple. By driving the vehicle and using it every day you are reducing its value. During a lease, you have to pay for that value that you take away by using it. If you bought the car, you would be paying for the entire value. Let me show you the math.
Purchase vs Lease Payments
Cost: $50,000 (w/ 50% residual)
Term: 48 months
Term: 48 months
Payment: $1041.67/ month
Cost is one of the most important factors that consumers consider when making their purchase. A lower payment is usually coupled with one of the other lease benefits and together they make a very good argument for leasing.
Cash, Finance or Lease... Oh My!
Leasing is just one of many options. It has a lot of benefits over the alternatives.
The Latest and Greatest
Car manufacturers spend millions every quarter to advertise their latest models. They highlight the sleek lines and new styling cues; they lay claim to being the first with this or that technology; they expound on their advanced sourcing or manufacturing processes to give the ultimate impression that their new model is the latest and greatest available. Many consumers buy into this.
Many lessees opt for this financing strategy because they want the newest gadget or style. They want the status or the attention that comes from a sense of exclusivity.
Simply swap keys
A lessee knows that they will be able to turn in the keys at the end of their lease and jump into the next greatest model that is out. Lessees don't have to fight with sales managers over resale or trade value or make up for depreciation they absorbed when they bought it new. They only pay for their time in the car and they walk away or swap keys for a new one.
Factory Warranty Provides Peace of Mind
When you finance a new car, whether lease or purchase, you will have a factory-backed warranty guaranteeing every aspect of the vehicle. Any defect in material or craftsmanship is covered under that protection plan.
New cars have an expectation of quality: nothing should break for a long time. If something does then the customer can take it back to the dealer, get a courtesy car in most cases, and the dealer will replace or repair at no cost to the owner.
While this is not a benefit of leasing only, it is usually a major supporting factor that leads buyers to the lease option. Generally speaking, manufacturer's warranties are for 4-5 years/ 40 -50,000 miles, so the lessee will be covered for the duration of their lease.
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Negative Equity Can Be a Killer
Those that owe more than their vehicle is worth are in a negative equity situation, referred to in the business as being upside down on their loan. It is not a fun position to be in especially if you don't carry gap insurance.
What does it mean exactly?
Well, let's say your KBB (Kelley Blue Book) value is $5,000 in the best condition. You still owe the bank $10,000. You are $5k upside down. When you go to buy a new vehicle, the seller will appraise your trade very close to the KBB value, leaving that $5k to deal with.
Now let's pretend that you want a car that costs $20,000. When you are upside down you will have to transfer that $5k to the new loan, making your total $25,000. Check out the table below for the breakdown.
Explaining Negative Equity
The New Car
Market Value: $5,000
Selling Price: $20,000
Debt to Bank: $10,000
Neg. Equity carried over: $5,000
Total Negative Equity: $5,000
Total Selling Price: $25,000
It should be noted that many people's response to leasing is that you have nothing to show for the vehicle at the end. This is absolutely correct. Alternately, those that spend 5-7 years paying off their vehicle find themselves in a situation that can be worse in many ways.
- Their warranty is likely expired, and they have undoubtedly paid some repair bills;
- Their vehicle is higher-mileage;
- Higher likelihood of accidents or damage reports on Carfax;
- The vehicle has 5-7 years of wear and tear.
It won't have a lot of value aside from being a good down payment. When leasing, your payments are smaller so you can easily plan on saving a few bucks each month to help when the lease matures and its time to get another vehicle.
While there are many other reasons why leasing is good for some people, the focus of this article is to highlight several of the most common. Additionally, this is not meant to be an exhaustive explanation of leasing, simply to provide a fundamental understanding.
Is Leasing Right for You?
There is no right or wrong answer for the question of whether to lease or purchase. Each solution has its pros and cons, and they should be carefully weighed to determine what is best for each consumer.
Please feel free to share your experience with leasing in the comments section. Remember, this is not car buying advice or even a complete explanation of leasing. Hopefully, you have a basic understanding of it now, and the word is less intimidating. Thanks for reading!
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
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© 2018 Steven P Kelly