How Car Leases Work: Payments and True Costs
Car leasing is essentially renting a vehicle for 2-4 years with the option (but not obligation) to purchase at lease end. You pay for the vehicle's depreciation during your lease term plus interest (called "money factor") and fees. Monthly lease payments are typically 30-50% lower than financing the same vehicle, making leasing attractive for driving newer vehicles with lower monthly costs.
Lease payments are calculated using four main factors: capitalized cost (vehicle price minus down payment/trade-in), residual value (projected value at lease end), money factor (interest rate divided by 2,400), and lease term. The depreciation portion equals (capitalized cost - residual value) ÷ number of months. The finance charge equals (capitalized cost + residual value) × money factor. Total payment is depreciation + finance charge + taxes.
Residual value significantly impacts lease costs. Vehicles that retain value better have higher residuals and lower payments. A $40,000 vehicle with 60% residual value after 36 months ($24,000) costs less to lease than one with 50% residual ($20,000) because you're paying for less depreciation. Luxury brands like Lexus and Toyota typically have higher residuals than domestic brands, making them relatively cheaper to lease.
Lease restrictions include annual mileage limits (typically 10,000-15,000 miles), excess mileage charges ($0.15-$0.30 per mile), and wear-and-tear penalties. Calculate your annual mileage accurately—underestimating and paying excess mileage fees costs more than purchasing higher mileage upfront. Excess wear includes dents, scratches, tire wear beyond normal use, and interior damage. Budget $500-$1,500 for potential end-of-lease charges.
Lease vs. buy analysis depends on your situation. Leasing makes sense if you: want lower monthly payments, drive less than 15,000 miles annually, prefer driving new vehicles every few years, and can afford continuous payments. Buying makes sense if you: drive high mileage, want to customize your vehicle, prefer no mileage restrictions, or plan to drive the vehicle past warranty expiration. For long-term wealth building, buying and holding vehicles 8-10 years minimizes transportation costs.