Understanding Car Leasing Terms
Last updated October 2023
When you lease, you pay to use a vehicle for the length of your contract—typically two to five years. When the lease is over, you return the car to the dealership or buy it by paying for its remaining value.
For most consumers, leasing will cost more than buying, even though advertised monthly payments make it appear less expensive. But unless you purchase the wheels at the end of your lease, you have to give back the car and won’t own anything, and you’ll have to lease or buy something else—starting a process of paying for steep depreciation all over again. Plus, you can’t customize a leased car, drive it farther than preset annual mileage limits, or damage the car without paying fees to the car’s real owner.
Unfortunately, getting a good deal on a car lease is considerably more complex than when buying. With leasing, the financing (lease contract) is what gets you the car, rather than a separate transaction. You usually can’t find a good price at one dealer, and then get a bank or credit union to buy the vehicle and lease it to you. As a result, you have to find a dealer that both charges a low price and also offers a good deal on lease financing.
Dealers love this complexity, and often throw in costs without your knowledge. But if you want to lease, you still can—and should—get competitive bids. In addition to getting bids on the price of the car, to get a good deal you have to find out about pricing and terms for several lease features.
Many leasing customers make a huge mistake by not working out the price of their vehicles first. Because the price of the leased vehicle (“agreed upon value” in leasing lingo) is a key element in the cost of the lease, collect the same information you would for buying wheels.
Shop for price first by getting bids from several dealers, then ask each about lease terms they offer. There are several things to consider:
The “lease term” or “duration” is the amount of time you have contracted to lease the vehicle (24 months, 36 months, etc.).
“Capitalized cost” (or “cap cost”) should be separated into “gross cap cost” and “adjusted cap cost.” Gross cap cost includes the agreed-upon price of the vehicle plus any fees, extended service plans, gap insurance premiums, and other add-ons you must pay upfront. Adjusted cap cost—the gross cap cost less any reductions resulting from a trade-in, down payment, or rebate—is the amount financed with the lease.
Capitalized Cost Reduction
“Capitalized cost reduction” is lease-speak for down payment plus the value of any trade-in and/or manufacturer rebates.
“Residual value,” the value the leasing company theoretically estimates that the vehicle will have at the end of the lease term, is usually figured as a percentage of MSRP. For example, a $50,000 MSRP vehicle with a residual percentage of 60 percent on a two-year lease is estimated to be worth $30,000 at the end of those two years.
The difference between residual value and adjusted capitalized cost is the amount of principal you will have to pay off during the lease term (you will also have to pay a finance charge, or interest, on the amount of money the leasing company has tied up in the car). Therefore, the higher the residual value, the lower your payments.
Residual percentages and residual values vary with lease term and miles driven per year. Some makes and models of vehicles retain their resale value better than others, and therefore have higher residual values. In addition, manufacturers sometimes agree to buy back cars at lease-end for more than the car is likely to be worth on the market. By subsidizing the residual value this way, car manufacturers keep lease payments lower than they otherwise would be in hopes of leasing more cars.
End-of-Lease Purchase Price and Option to Purchase
Lease contracts generally give customers the option to purchase the vehicle at the end of the lease for the residual value, plus a purchase option fee many plans impose.
A leasing company may use either a “money factor” or “annual percentage rate” (APR) of interest to express the way it calculates the finance charge. To calculate the APR for a given money factor, multiply the money factor by 2,400.
Money factors vary for different models of vehicles and lease terms, and different leasing companies often use different money factors. All else being equal, a lower money factor means lower payments.
Many leasing companies charge an “assignment fee,” essentially a processing fee, to set up a lease. The amount varies, but $400 to $600 is common.
“Allowable miles,” the number of miles the lease allows you to drive for no additional charge, typically range from 12,000 to 15,000 miles per year.
“Additional contracted miles” are miles above the allowable miles you contract for in advance at the time the lease is executed for an extra charge, usually expressed in cents per mile.
“Excess uncontracted miles” are miles you drive above the allowable miles and above “additional contracted miles” in the lease. The penalty for excess uncontracted miles at the end of the lease, usually expressed in a cents-per-mile charge, can be quite costly.
Early Termination Penalty
Most leases impose a substantial “early termination penalty” for terminating a lease before it expires. It may cost several thousand dollars, depending on when the lease is terminated—the earlier it’s ended, the higher the early termination penalty.
“Gap insurance” protects you if your leased vehicle is stolen or totaled in an accident. From the leasing companies’ point of view, total loss of the vehicle is a form of early lease termination. Typically, your auto insurance company would pay off the claim, but what happens if the car’s market value is less than the amount you owe the leasing company? This difference is called the “gap,” and you would be responsible for paying it to the leasing company. Some leases provide a “gap waiver” that protects you against such shortfalls if you meet certain insurance requirements, but others do not. If you need it, buy gap insurance from the leasing company.
Option Discount Adjustment
Car manufacturers sometimes offer special discounts on option packages, and leasing companies often treat these discounts in special ways when calculating residual value.
For example, the invoice for a vehicle model might show an MSRP of $1,000 for a “power package” and a $600 discount for the package—a net price of $400. The MSRP for vehicles with the power package is $400 higher than vehicles without it. But when this model is leased, the MSRP used to calculate residual value (residual value equals MSRP times residual percentage) will include the undiscounted price of the power package ($1,000) rather than its $400 discounted price. In other words, the $600 package discount is added to the MSRP before residual value is calculated.
This peculiar piece of bookkeeping is good for you because it means your residual value will be higher—and payments lower—than they otherwise would be.
Even More Lease Language
Auto leases include a number of other features and requirements, among them:
A security deposit, typically one month’s lease payment, is usually due when you sign. You will get the security deposit back at the end of the lease, unless it is applied to settling excess charges you incur.
Lease plans have stringent “excess wear and tear” provisions, and leasing companies will charge you if they determine that you have exceeded them. You’ll have little say as to whether repair bills are reasonable.
If you do not choose to purchase the vehicle at the end of your lease, some leases charge an administrative fee, usually referred to as a “disposition fee.”
Leased vehicles usually have stringent insurance coverage requirements. You may have to buy more insurance than you would buy on a vehicle you purchased.