What is Car Leasing and How Does it Work?

Most consumers are aware of car leasing and how it usually translates into lower monthly payments, but most really don't understand what a lease is and how it works.

A simple way to describe leasing is to say that it's similar to renting a car, but this is misleading. The truth is - leasing is just another method of financing a vehicle.

Unlike a traditional car loan, leasing is a type of financing where you pay for the use of a vehicle instead of the purchase of a vehicle. The use of a vehicle includes its depreciation cost (the loss in value), any excessive mileage, and any excessive wear and tear you cause during your lease.

As with traditional financing, you'll have to pay a finance charge (interest rate) on the purchase price of the vehicle. That's right - the vehicle is actually purchased by a leasing company before they turn around and lease it to you. To a dealer, a lease is no different than a regular sale.

Think of a leasing company as a finance company - they do the same thing. In fact, many leasing companies are simply banks that do both car financing and leasing.

When you take out a car loan to buy a vehicle, a portion of your monthly payment goes toward paying off that vehicle (the principal) while another portion pays the finance charge.

In a lease, your payment goes toward the use of the vehicle plus the finance charge. You never pay off any principal.

The overall cost of financing during a lease is always higher than a traditional car loan (assuming the same interest rate) because you're never paying off any principal. If the purchase price of the vehicle was $25,000 and your lease term is 3 years, you will be paying interest on the full $25,000 for that entire term.

With a car loan however, a good portion of your monthly payment goes toward paying off the principal, so you're constantly reducing the amount you owe to the bank as time goes on - thus reducing your finance charge.

One big advantage to leasing is that you simply return the car back to the leasing company and walk away at the end of your term, leaving them with the hassle of selling the vehicle.

Let's assume you lease a car worth $25,000 and the leasing company is able to sell it for $15,000 at the end of the lease. They are now left with what seems like a $10,000 loss - but that loss is actually the use of the vehicle which you paid off as part of your monthly lease payment. See how this makes sense now?

The leasing company makes money by charging you an interest rate on the $25,000 used to purchase the vehicle, plus they charge an acquisition fee and a disposition fee which adds another $500 to $1,000 to their profit. (See Leasing Terms Explained)

Once you understand the concept behind leasing, it becomes a lot easier to compare leasing against traditional financing and to know whether or not you're really getting a good deal.