How Does Leasing a Car Work?

If leasing a car sounds like a good idea, it’s important to know the ins and outs of a lease agreement and how it differs from traditional financing. Smart shopping will depend on a few key figures to get the best deal out of your car lease.

Leasing a car offers drivers the chance to obtain a new car without a hefty down payment based on the following principles:

  • Understanding lease options and knowing lease terms
  • Making lease payments and knowing the car's residual value
  • Paying a down payment

Types of Car Leases

Closed-End Lease

There are two types of leases you can choose when leasing a car, with a closed-end lease being the most common for consumer leases. With a closed-end lease, you can return your car at the end of the contract term and walk away, assuming the car has not been excessively damaged (meaning anything outside of normal wear and tear) or driven over a certain number of miles.

This type of lease assumes that the vehicle’s value at the end of the lease, also known as its residual value, is predictable and that the vehicle won’t be driven in extreme conditions or for extreme distances. (We’ll learn more about residual value when we discuss lease payments.) If the vehicle is actually worth less than the anticipated amount when you turn it in, the leasing company absorbs the loss, not you.

Open-End Lease

An open-end lease is generally used for commercial business leasing, since the lessee takes on the financial risks. If you were to choose an open-end lease, you would be responsible for paying the difference between the estimated value of the car at the end of the lease (the residual value) and the actual market value. This could be a large sum if you’ve driven over the predicted mileage or if the market value of the vehicle has dropped significantly.

After you determine which lease works best for you, review the contract terms of the lease.  These terms can include a maximum number of miles driven annually, necessary exterior and interior maintenance, and avoiding automotive wear and tear. According to the Federal Trade Commission, “When you lease a vehicle, you have the right to use it for an agreed number of months and miles.” If the lease terms are not upheld, steep penalties can occur. It’s important to consider your ability to maintain and care for a vehicle, as well as maintain the right amount of car insurance before agreeing to a lease contract and risking heavy fines.

Car Lease Payments

Car lease payments are calculated by the residual value of the car at the end of the lease, unlike full financing which includes the upfront cost of the car and any additional costs (like registration and taxes) not covered by the down payment.

Residual value is the difference between the original cost of the car and the estimated cost of the car after your lease is up.

With this estimated value spread out over the duration of your lease, the lease’s monthly payments often end up being much less than a loan payment. However, it’s important to note that a renting fee and financial interest are also often incorporated into lease payments. Another difference is that lease payments are due at the beginning of the month, rather than at the end like loan payments. For this reason, your first month’s payment is due the day you sign the lease, not at the end of the month.

Car Lease Down Payments

Once the residual value of your lease is calculated, you’re ready to make a down payment on your new car. The down payment for a lease is usually negotiable and determines the monthly payment amount – the more money you put down, the lower your monthly payments will be. To make your monthly rate as low as possible, try to negotiate as large a down payment as your budget will allow. It’s also important to note that before you drive your new car, the initial payment will be due in full and will incorporate fees and taxes. (More on sales taxes when we talk about leasing vs. buying.)

Still not sure if you should lease or buy your next vehicle? Analyze the pros and cons of each and see which financing plan best fits your budget.