What is a Car Lease?

I remember when I was younger that I had no idea what a car lease was – I knew the monthly payments were smaller so I thought that was good – and that was pretty much the extent of my knowledge! :) I’m guessing there are other people out there who are in the same boat that I was in…

CarVintage.jpgBasically a vehicle lease is a tool that allows you to pay for the depreciation of the car only.  This is opposed to a car loan, in which you borrow the money to purchase the car outright.  For example, let’s say we have a $30,000 car.  You could take out a loan to buy the car and perhaps the monthly payment is $580 for a 5 year, 6% interest rate loan. After 5 years, the car may be worth $10,000 – $20,000 depending on the level of care you put into it and also depending on the re-sale characteristics of the vehicle make and model.  If you plan on selling the car after 5 years (after the loan is paid off), then you will pocket the money you get from selling the car, right?

Some people may look at that and say, well why did I fork out $580/month for those 5 years  when I knew I was going to sell the car and get some of my money back? They might consider leasing the car instead.  Since the lease allows them to pay for the depreciation only, then instead of paying off $30,000 within 5 years, maybe now they are only paying off $10,000 – $20,000 depending on the estimated value of the car at the end of 5 years.  This would lower the monthly payments to the $190-$390 per month range.  Of course, at the end of the 5 years you return the car to the dealership and you have nothing to show for it.

The monthly payments are calculated ahead of time based on the expected rate of depreciation and an estimation of how much mileage you will put on the car.  A run of the mill lease will allow for maybe 15,000km per year with a very hefty charge per km over the agreed upon limit.  For example, if you drive the car 20,000km per year, then you will have an overage of 5,000km per year for 5 years for a total of 25,000km.  If the overage charge is 12 cents per km, you will have to pay an additional $3,000 when you return the car!

When a situation like that arises, you normally have the option of "buying out" the car at the end of the lease.  If you buy the car at the end of the lease can sell it or keep it. Let’s give an example:

Ken enters into a lease agreement for a new car that is worth $30,000.  It is a 5 year lease with an allowance for 15,000km per year – for every kilometer over that amount there will be a 12 cent charge. The end value of the car is estimated to be $15,000 after 5 years. The interest rate is 6%.  This will give Ken a monthly lease payment of about $300.  Ken drives 20,000km per year so when the lease ends he is 25,000km over his allowed amount.  If Ken wants to return the car and terminate the lease he will need to also hand over a cheque for $3,000 to pay for the extra mileage on the car! BUT Ken has taken very good care of the car and knows that he can probably sell the car for $17,500 so he decides to buy out the car for the $15,000 (the end value of the car as pre-determined by the dealership).  Since he buys the car, he does not need to provide the $3,000 for using the extra kilometers. He gets $17,500 for the car selling it privately and therefore walks away with $2,500 in his pocket.

The per km charge in the lease agreement is designed to offset the lower price that a higher mileage car would be expected to fetch when the dealership transfers the car to their used-car lot for re-sale. 

 




Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 3 comments
  • Suzanne Mcguire

    A very nice informative article! Purchasing a new car using a car loan and letting out a car on lease are contradictory. In fact, this article helped me to know some of the basic facts of which I was unaware :)

  • Monthly Car Lease

    All true..and with leasing you should never have to pay a downpayment or deposit. Generally, downpayments are marketing ploys which are used to make it seem like you are getting a lower monthly payment than you really are. The down payment will not lower your total cost to lease. Preserve your money and get the best deal you can. That’s the whole idea of leasing.

  • Gary Shapland

    Great car leasing article and one worth revisiting as time goes on and the recession moves from stage to stage. In the UK we have seen a huge increase in people leasing cars. They no longer wish to put them selves in debt with their lease cars as they no longer have job security to take on big car loans. Instead they are taking car leasing as an option and simply paying the depreciation on the car and enjoying the benefits of driving the newest and latest lease cars