Most people don't have the cash on hand to buy a car outright, but still need a vehicle to get them to work or school. These potential car buyers have to choose between two options: financing the car purchase or leasing the car. Financing a car, or taking out a car loan, is relatively easy to understand since it works in a similar fashion to mortgages and other kinds of secure loans. Leasing, on the other hand, is a little more complex. The information below will give you an idea about how the leasing process works.
What is Leasing?
A car lease is essentially a long term car loan agreement. People who lease cars do not own their cars, and generally must return the vehicle at the end of the lease term. Since the way monthly lease payments are calculated is relatively complex, it's often difficult for consumers to decide whether leasing or buying is a better deal.
The best way to understand lease pricing is to view it from the car dealer's perspective. In that sense, they dealer isn't lending you a vehicle, but rather an asset worth a certain amount of money. By the end of the lease term, the entire value of the asset must be returned to the car dealership, plus interest and any other administrative costs. However, a car's value does not remain constant, but rather reduces with time and use. This is known as "depreciation." Lease payments are typically the amount the car depreciates divided by the number of months in the lease term, plus interest.
For example, suppose you lease a car worth $24,000 for two years. From the car dealership's perspective, they just gave you a $24,000 loan. The car dealership calculates that after two years, with normal use, the car will be worth $12,000. Since the lease term is 24 months, your monthly payments will be $500 plus interest, taxes, and fees. At the end of the lease term, you will have paid the dealership $12,000 plus interest, and will return the car, now worth $12,000, to complete the rest of the loan. You may also be able to buy the car for its current value.
Since lease payments are tied to the value of the car, they are often lower than monthly car loan payments. Lessees need to be careful before signing on to "deals" that feature lower monthly payments. An amount equal to the car's depreciation must be paid back over the course of the lease term. Interest is calculated regularly as a percentage of the depreciation that is not yet paid back. The lower the monthly payment, the more depreciation value is left over for you to pay off, causing the interest rate to be greater.
What Can You Do with a Leased Car?
The other major advantage to taking out a car loan is that you now own the car. You can drive it as much as you like, modify it however you want, or sell it when you don't want it any more. A leased car, on the other hand, is not yours. As a result, you have much less freedom. You can't change the car in any significant way, and most lease terms limit how many miles you can put on the car.