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The basics of a car lease agreement

People looking over a car lease
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Leasing a car instead of buying is a great way to get a vehicle without a long-term commitment. But once you pick out a car, you’ll be presented with a lease agreement, which is a contract between you and the leasing company.

Unfortunately, the contract may be filled with jargon you may not fully understand. Before you seal the deal, familiarize yourself with the basic elements that make up this type of document. Here’s what you need to know to make an informed decision.

How does car leasing work?

When you lease a car, you’re essentially paying the leasing company (or lessor) to drive a car it owns for a set period of time, usually two or three years. Most often you’ll be required to lease a new vehicle, although some dealerships will offer leases for certified pre-owned used cars. The payments on a lease are designed to cover the depreciation of the car during that period, plus interest, so they’re often cheaper than an auto loan on an equivalent vehicle would be.

The process of leasing is similar to the process of buying. You’ll visit local dealerships to shop around, compare prices and pick a vehicle, then the dealer’s finance department will draw up a car lease contract for you to review and sign. At the end of your lease, you may also choose to buy the car with cash or a lease buyout loan or simply walk away.

The difference between a car lease and a car loan

A car lease gives you “ownership” over a vehicle for a certain amount of time, but you’ll be limited by the terms and conditions laid out by your lessor. A car loan, on the other hand, gives you money that can be used to buy a car. While you’ll make payments on your loan for a number of years, the car is yours to keep.

Buying a car outright is typically a better option for people looking for a long-term vehicle or those who do a lot of driving — car leases typically impose mileage limits, and exceeding those limits could add significantly to the cost of your lease. Additionally, you may end up spending more in the long term with leasing than you would if you bought a car and used it for many years.

What is a car lease agreement?

A car lease agreement represents a legal contract between you and the company that’s leasing the vehicle to you. In many cases, leasing a car is similar to renting an apartment. The agreement lays out all of the terms and conditions of your contract, including the monthly costs, the length of the lease, restrictions, additional fees and more.

As you’re presented with an auto lease agreement, it’s crucial that you understand what you’re getting yourself into. While a lease offers you the chance to drive a new vehicle for less than what you’d pay if you were buying, you may end up getting slapped with penalties.

What is in the vehicle financing agreement?

The first sections of your car lease contract will likely be focused on what you’ll be expected to pay as part of the deal, including how the monthly payment is calculated. Then it will provide information about early termination, mileage limits, end-of-lease options and more.

Look out for these elements:

  • Acquisition fee: An acquisition fee is the charge that leasing companies assess to arrange the lease. It’s generally not negotiable.
  • Amount due at signing: One of the first sections of the agreement states exactly how much you will need to pay when you sign. That amount includes your down payment, but the agreement will also break down any fees, credits or rebates that factor into the total amount due. For example, trading in another vehicle will lower the amount due.
  • Buyout price: Look for the amount you may be able to purchase the vehicle for — along with any related fees — at the end of your lease period.
  • Capitalized cost: Also called cap cost, this is the selling price of the vehicle, which is used to calculate depreciation and how much you owe.
  • Capital cost reduction: This includes any down payments, trade-ins and dealer rebates that lower the cost amount being financed.
  • Disposition fee: If you decide to walk away from the lease instead of trading it in for another lease or buying the vehicle, you’ll be charged this fee. The disposition fee covers the costs the dealer incurs to prepare it for resale. You’ll often be able to get the fee waived if you sign up for a new lease.
  • Early termination fee: The agreement should explain any fees you’ll be charged if you need to get out of your lease early. Ending a lease early usually comes at a steep cost.
  • Excessive use: Your lease will show you how many miles you’re allowed to drive each year. If you exceed that limit, you’ll be charged a fee based on the number of miles you drive. It may also reference damage to the vehicle that you’ll need to pay for when the lease is over.
  • Money factor: This helps determine the interest rate on the loan. To find out what your interest rate is, multiply the money factor by 2,400. For example, a money factor of 0.0032 times 2,400 gives you an interest rate of 7.68 percent.
  • Monthly payments: The agreement should state the amount you’ll pay each month and include a detailed breakdown of the factors — including sales tax and estimated depreciation — that were used to determine that amount.
  • Residual value: This is the value of the vehicle at the end of the lease due to depreciation. Cars that depreciate more slowly than others have a higher residual value and lower monthly payments.

Restrictions in the car leasing agreement

Part of the purpose of the agreement is to explain the restrictions that are placed on your use of the car. Look for these factors:

  • Customizations: Because the leased vehicle doesn’t belong to you, you’re not allowed to make any customizations, such as adding a new stereo system or painting the vehicle.
  • Early termination: If you’re not sure whether leasing is right for you, you’ll be better off buying. If you terminate the lease early, you’ll be assessed a fee, and the earlier you end the agreement, the more expensive it will be.
  • Excessive wear: Your agreement will likely say that you must return the car at the end of the lease with no more than “normal” wear. Read this section closely so you clearly understand the condition you must maintain for the car.
  • Maintenance: The car you’re leasing is sure to need some maintenance during the period you’re using it, and it might even need significant repairs. Make sure to read the section of your agreement that explains your responsibility for covering these costs.
  • Mileage charges: Your agreement will stipulate a certain number of miles, usually 15,000 or less, that you are allowed to drive each year with no extra charge. It will also state the amount you will be charged per mile if you exceed this threshold.

What happens when the auto lease ends?

You have three options when your lease comes to an end:

  • Trade it in: With this option, you’re essentially replacing your lease that just ended with a new one.
  • Walk away: If you don’t want to lease a new vehicle right away or you’d rather buy your next car, you can return the vehicle and simply walk away.
  • Buy the car: If you like the car you’ve been driving and want to purchase it instead of a different one, you can pursue this option. The purchase price will already be listed in your vehicle lease agreement, so you can shop around and compare prices to determine if it’s a good fit for you. Some lenders offer specialized auto loans specifically for lease buyouts.

As you near the end of your lease term, you may start hearing from the dealership to find out how you want to proceed. Take your time to consider each option carefully and determine the right fit for you.

The bottom line

Leasing a car has its pros and cons, but if you’ve already decided that you want to lease instead of buy, it’s important to know how to read the agreement. Not only will it help you understand how your monthly payment was calculated, but it will also give you information on how you’ll need to handle the vehicle over the term of the contract.

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Written by
Ben Luthi
Contributing writer
Ben Luthi is a personal finance and travel writer who loves helping people learn how to live life more fully. His work has appeared in several publications, including U.S. News & World Report, USA Today, Yahoo! Finance and more.
Edited by
Student loans editor