How Does Leasing a Car Work?

What Is a Car Lease?

Leasing a car differs from financing one because you don't own the vehicle once your term is up. Think of it like renting an apartment, except instead of paying a landlord and abiding by a rental agreement, you'll make lease payments and follow the leasing company's rules on how you can use the car.

A lease is a contract you must follow as long as you have the car. Unlike a car loan, you can't sell your car during the lease term without facing penalties. When the lease ends, you generally have two options: You can return the vehicle to the leasing company or dealership and pay any agreed-upon fees or—if your lease allows—you can purchase the car.

How Long Is a Car Lease?

Car lease terms can vary, but 24-, 36- and 48-month terms are common. Keep in mind, the length of your car lease may affect your monthly payment amount and miles allowance. Longer lease terms will generally result in a lower monthly payment, though you'll pay more in financing costs, also called money factor, over time—more on that later.

When choosing a lease period, consider your lifestyle and when you might want to exchange it for a newer vehicle. Choose a term that suits your needs because you'll have to pay an early termination fee if you return the car early.

Pros of Leasing a Car

A car lease allows you to enjoy the benefits of a newer car with minimal responsibilities outside of your payment and routine maintenance. While you may not own the vehicle outright, there are several benefits to leasing a car.

• Enjoy more affordable payments. Lease payments are typically lower than the monthly loan payments for a car purchase. That's because lease payment amounts are based, in part, on the car's depreciation during its lease term, not the car's full value.
• Qualify with a smaller down payment. You can usually lease a vehicle with a smaller down payment than financing a car purchase, which may help you get the car for less upfront.
• Drive a newer car. If you want to always drive the latest-model cars, leasing could be less expensive than buying and selling a vehicle every few years.
• Benefit from warranty coverage. Your car will generally be covered by the manufacturer's warranty throughout the lease term.
• It's easy to return the vehicle. You don't need to worry about selling or trading in the vehicle at the end of the lease, although your lease may allow you to purchase the car at the end of the lease term.
• It could be purchased for less than market value at the end of the lease term. Leasing companies may allow you to purchase the vehicle for less than you would be able to purchase it otherwise.

Cons of Leasing a Car

Leasing a car isn't for everyone. Weighing the downsides of a car lease against its benefits can help you determine if leasing is a good option. Here are some situations where leasing a vehicle may not make sense.

• Leases limit your miles. Car leases restrict the number of miles you can put on the vehicle each year. Mileage limits are usually 10,000 to 15,000 miles annually.
• You could face fees and penalties. Leases often impose a lengthy list of charges and penalties you could incur for extra miles, excess wear and tear and other violations of lease conditions. For example, if you drive over your lease's limit, the excess mileage fee could range from 15 to 25 cents per mile.
• You could incur an early termination fee. If you no longer need the car, getting out of a lease early can be expensive due to the early termination fee. And you might not be allowed to take the car with you if you move to a different state.
• Modification may not be allowed. You usually can't customize the look or features of your car during the lease unless you pay hefty penalties when you return it.
• Payments won't count toward purchase. If you choose to purchase the vehicle once your lease term is up, your lease payments won't be counted toward the car's value.
• It could be more expensive long-term. In the long run, leasing will generally cost you more than buying and holding on to a vehicle.

Learn more >> Is Leasing a Car a Good Idea?

What Credit Score Do You Need to Lease a Car?

The minimum credit score needed to lease a car varies depending on the lender or dealership, but typically, you'll need a credit score of at least 670, which is considered good credit. As with taking out a car or home loan, maintaining a higher credit score could improve your odds of approval and favorable lease terms. If your credit isn't ideal, you may only be able to qualify for a lease with higher upfront costs and monthly payments.

Some dealers offer leases on used vehicles, which may be easier to qualify for if you have bad credit. However, the lease may have high fees and lack some of the advantages that come with leasing a new car. For example, you may be responsible for all the repairs and maintenance during the lease.

You might be better off trying to improve your credit and finances before looking for a lease. You could also consider purchasing a used car that's a better match for your budget.

Learn More >> What Credit Score Do I Need for a Car Lease?

What Documents Do You Need to Lease a Car?

Applying for a car lease requires many of the same documents you must provide when purchasing a car, such as:

• Driver's license: Your driver's license doubles as personal identification and confirms your legal ability to drive the car you plan on leasing. If you have an out-of-state license, you may want to update it to your new state, as some states require a local license to lease a vehicle.
• Proof of residence: Be prepared to submit a copy of a utility bill, bank statement or other proof that verifies your identity and address.
• Income verification: The lending company will want proof of income to verify you earn enough to make your monthly car lease payments on time. Generally, recent pay stubs, income tax returns and bank statements are accepted forms of verification, but double-check your lender's requirements to be sure.
• Credit score: Dealerships and lenders also want to run a credit check to gauge how well you manage debts. Remember, minimum credit score requirements vary by lender and dealership, but most look for a score of 670 or higher.
• Proof of insurance: Most states require drivers to carry a certain amount of liability insurance, including bodily injury and property damage liability coverage. Additionally, leasing companies usually require you to carry collision and comprehensive coverage, and many require gap insurance. Usually, when a lender approves your lease, they'll extend a grace period of up to 30 days for you to acquire coverage and supply them with proof of insurance.

What to Consider Before Leasing a Car

While leasing a car is a relatively straightforward process, it comes with a number of conditions, fees, and other factors you must consider. Here's a breakdown of several terms you'll likely see in a car lease agreement. Before you consider leasing a car, familiarize yourself with these terms and how they might affect your lifestyle and finances.

• Acquisition fee: This is an upfront fee some leasing companies charge to cover the administrative costs of setting up the lease. The fee ranges from roughly $600 to $1,100 and is paid upfront or rolled into your monthly lease payments.
• Buyout price: This is the price you must pay if you choose to purchase the car at the end of the lease. The buyout price may decrease over time as the car depreciates.
• Cap cost reductions: These are adjustments that lower the price of the car. For example, you can negotiate the sales prices, trade in a car or make a down payment to lower the cap cost, which could lower your monthly payments.
• Capitalized cost: Sometimes referred to as cap cost, this is the sales price of the car, which is negotiable.
• Disposition fee: This fee typically costs a few hundred dollars and covers the cost of cleaning, administrative tasks, and preparing your returned vehicle for resale.
• Drive-off fees: These are costs you pay upfront, such as the down payment and sales tax.
• Gap insurance: Insurance that covers the difference between a car's residual value and what your auto insurance company pays out if the car is totaled. Some leasing companies require you to purchase this and include the insurance premiums in your monthly payment.
• Lease term: The length of the lease, which is usually two to four years.
• Mileage allowance: Leases typically restrict your car's usage to a specific number of miles each year. You could incur an excess mileage fee if you exceed the mileage limit. You might take advantage of a high-mileage lease that allows you to drive more miles per year, but you may have to pay more each month as a result.
• Money factor: The money factor is essentially the interest rate on your car lease, but it's represented as a small decimal fraction. For comparison's sake, you can convert it to an equivalent interest rate by multiplying the number by 2,400. For example, a cap rate of 0.0025 equals an interest rate of 6% (0.0025 x 2,400 = 6).
• Purchase option agreement: Your lease may specify how much you can purchase the car for once your lease ends.
• Residual value: This is the car's value at the end of the lease, according to your lease agreement. The figure accounts for the car's expected depreciation. Generally, cars that hold their value well are the best to lease because lower depreciation can lead to lower monthly lease payments.
• Security deposit: The dealership or leasing company may require a security deposit. You'll get it back at the end of your lease, minus any charges for damage, excess mileage or other fees.

Learn More >> How to Negotiate a Car Lease

Should You Lease a Car?

Deciding whether you should lease a car, buy one or wait may require you to weigh their pros and cons.

A car lease can be a good option for drivers who prefer driving a new vehicle and don't want to pay for routine maintenance and car repairs. That's because the manufacturer's warranty typically lasts through the duration of the lease. This arrangement also benefits drivers looking for a more affordable way to get a newer set of wheels since monthly lease payments are generally lower than loan payments for a purchased vehicle. Additionally, you may lease a car with a smaller down payment than buying a car.

Leasing a vehicle could be a good option if you like the idea of simply returning the car at the end of the lease without the hassle of selling it. If you drive less than 10,000 to 15,000 miles per year, your mileage limits on a car lease may not matter to you. On the other hand, if you have a long commute or frequently take long road trips, then leasing a car may not make sense for you.

Learn More >> The Do's and Don'ts of Leasing a Car

How to Lease a Car

If you want to take advantage of the benefits of a car lease and you're comfortable with its downsides, here are some steps you can take to lease a car.

1. Review your credit. Check your credit score to make sure you qualify to lease a new car. Your score should fall in the "good credit" range—670 or higher.
2. Assess your budget. Review your finances to determine your available funds for a down payment and monthly car lease payments. Don't forget to factor in the costs of insurance, registration, gas and other car-related expenses.
3. Calculate your mileage limit. Determine how many miles you drive each year to help you choose the right limit. You may want to pad your mileage limit to help steer clear of costly overage fees.
4. Choose a car. Test drive and compare different cars to select the one you want to lease. Remember that with car leases, you're paying for the car's depreciation. Choosing a car that retains its value well with minimal depreciation could help you secure lower monthly lease payments.
5. Compare prices and terms. Shop around to see which dealership offers the best lease terms. You could try to pit lessors against one another to get the best deal.
6. Negotiate the car lease. It's essential to understand the car lease terms before signing the lease. Remember that some terms, such as the vehicle's cost, down payment requirements and mileage limits, may be negotiable. Also, verify the interest rate, which is referred to as the money factor in a car lease.
7. Sign the car lease. Review the lease to make sure the price and terms are what you agreed to during negotiations. Sign the lease only if you fully understand and agree with its terms and responsibilities.

Taking the time to review your budget, costs and lease terms can help prevent surprises down the road.

The Bottom Line

Understanding how a car lease works can help you choose the right vehicle, set appropriate mileage limits and negotiate the best deal. It's also wise to maintain good credit to qualify for the lease and receive favorable terms.

If your credit score is a roadblock to a good deal, you might consider taking steps to improve it before applying for a lease. Start by accessing your Experian credit report and FICO^® Score^☉ for free with Experian. You'll discover what lenders see when they review your credit. Resolve any issues you find and follow the best practices to build your credit.