JavaScript must be turned on in order for this site to display properly.

Personal and Business Banking

Auto Leasing Guide

Chapter 1: Leasing Hype Versus Reality

  • Summary
  • Article

Chapter 1: Leasing Hype Versus Reality

Remember, leasing is ONLY a financing option. It is important to understand how a lease works so that it isn't used to confuse you into thinking you're getting a better deal than you are. Read further for some lease pitfalls and tactics sometimes used to sell leases.

Chapter 1: Leasing Hype Versus Reality

The Lease Hype

If you're in the market to buy a new vehicle, someone may try to switch you to leasing. If you've been to a dealership, or visited an automotive web site, you may already know that. The pitch from many salespeople has been really successful, too. One study showed that only six percent of people planned to lease a vehicle when they entered a dealership, but thirty five percent ended up doing so before they left. These people were converted to leasing on the spot. Why did that happen? Most likely because the sales pitch pushed these two points:

  1. "More car for less money!" That's what we all want, isn't it? And if you believe the hype, leasing delivers that wish, too: "Lease it for just $199 per month!" And the ad is talking about a car you would pay $350 a month to buy!

  2. "No haggling, no confusing negotiations!" The dream of every car shopper. Lease a vehicle, the sales pitch says, and there's no pressure and confusion! Why wouldn't everybody lease?

The Reality

Leasing is simply another way to finance the use of a vehicle. A lease itself isn't good or bad – it's a financing tool. You need to fully understand how it works to decide whether this type of financing tool makes sense for you.

But first, you need to understand the reason the industry has pushed leasing over buying – it can be more profitable.

Just what is a lease? – In one way, it's just like renting a car. You pay for the use of someone else's vehicle. In a lease, you use the vehicle. You don't own it. There's one big difference in leasing and renting, though. If you're renting a vehicle, you can usually turn it in early if you want to without paying a big penalty. If you're leasing a vehicle, you usually pay a substantial penalty to turn it in early.

Why do lease payments seem so cheap? – Lease payments are typically lower because you are paying to use the vehicle – not to own it. Although you pay interest on the money involved as with a conventional loan, you don't pay back the full cost of the car over the term of the lease. You just pay for the drop in value (or depreciation) while you drive it. You then return the car (or buy it) to satisfy the rest of the loan amount. Lease payments are generally based on three things...

  1. Residual Value – This is the estimated value of the car at the end of the lease term. You pay off the residual value at the end of the lease by returning the car or buying it. You'll pay for the decline in value from the initial lease amount to the residual value over the term of the lease as part of your monthly payment. Generally, a car that holds its value is a better candidate for leasing because the residual value represents a higher percentage of the initial lease amount.

    For example, say you're leasing a car with a $20,000 initial lease amount for 36-months. At the end of the term, the residual value is estimated at $5,000. The difference between the opening amount and the residual value is $15,000. You'll pay off that $15,000 as part of your monthly payment over 36 months. If the residual value for the car was set at $2,000 instead of $5,000, you would have to pay back $18,000 during the same term. As a result, your monthly payments would be higher for a car with the same initial lease amount.

  2. Principal – As in a regular loan, principal is the amount you borrow. As mentioned above, you gradually pay part of the principal back during the lease term and a lump sum for the residual value at the end. In our example, you would be paying down $15,000 of the $20,000 initial lease amount with your monthly payments. If you had a 36-month conventional auto loan instead, you would be paying off the full $20,000 with your monthly payments over the same term. That is the main reason lease payments are lower than buying.

  3. Interest – You are also paying interest on the principal each month, although lease companies generally don't call it interest when you lease. That makes it harder for you to find out how much you're really paying. Like a conventional loan, the interest portion of each monthly payment starts out higher and declines as the principal is paid down. Since the residual value isn't paid until the end, you can count on paying interest on that every month for the full term of the lease.

    If you get a conventional loan for the same term as a lease, you'll generally pay less interest on the loan because you pay down the principal faster. In our example, your lease payments reduce the principal from $20,000 to $5,000 at the end. In a conventional loan, your payments would reduce the $20,000 to zero in the same time.

Why have leasing companies been able to make such bigger profits on leasing versus selling the same vehicle? – Because leasing, even with the new lease regulations, doesn't require as much disclosure as buying a vehicle. Did you know leases don't tell you an interest rate? Did you know leases don't clearly tell you what you're receiving for your trade-in? And did you know leases many times hide the important facts of the lease – the ones that cost you money – in tiny print on the back of the lease?

Two of the hidden dangers – leases can get you in trouble in many ways, but here are the big problems:

  • Unrealistic mileage restrictions – In a lease, you pay a penalty if you drive a vehicle beyond the miles stated in your lease. For instance, the lease contract might allow you to drive 15,000 miles per year. That's fine, if you drive 15,000 miles a year. But some leasing companies deliberately give you an unrealistic mileage limit, and then charge you high rates for excess miles.

    For instance, they know from the miles on your current car you drive 40,000 per year, but only give you a mileage allowance of 15,000 miles. Penalties when you run over the 15,000 miles can run thousands of dollars. Since the miles a car has been driven affect resale value (residual value), an unrealistically low mileage limit inflates the estimated residual value. That allows the leasing company to offer you a smaller monthly payment up front, which helps get you to sign the contract. Of course, you'll get the big surprise with the mileage penalties at the end.

  • Excessive wear and tear charges – Own a car, and you can ding it up all you want. It's yours. But because you don't own a lease vehicle, you pay money if the vehicle has excess damage over normal wear and tear when you finally give it back to the leasing company. But who determines "normal wear and tear?" The leasing agent, such as the dealership. And unfortunately, many leasing agents in the past have charged customers ridiculous amounts for wear and tear – they've turned wear and tear into a profit center. What's your recourse if this happens to you? Virtually none. The lease contract gives the leasing agent the right to do this.