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How Does Leasing a Car Work?

Car prices are pretty insane right now. And that means more and more people are turning to car leases to get the car they want . . . without really understanding how they work.

I’m going to break down what a car lease is—and show you how you can still get a cool ride without throwing a bunch of money out the window.

What Is a Car Lease?

A car lease is a contract where, instead of buying a car, you pay in monthly installments to drive it for a set amount of time (usually two to three years). It’s basically a glorified rental car—but unlike a rental, leasing is a form of debt. Leasing is also the most expensive way to drive a car.

Basically, the person or company who owns the car (the lessor—usually a car manufacturer or dealership) will lease the car to someone (the lessee). The lessee has to make monthly payments until the lease term is up. Then they’ll hand the keys back over to the lessor.

Hear me loud and clear: Leasing is a complete rip-off. In fact, my good friend Dave Ramsey calls leasing “fleecing” because getting “fleeced” means getting taken advantage of financially. And he’s right on the money with that nickname.

Listen, I get wanting a nice car. But the damage leasing does to your budget is not—I repeat, not—worth it. Trust me, there’s a better way to get a car. Plus, you can’t build true wealth if you’re going into debt (again, a car lease is actually debt) just to look rich.

I’ll get into all the reasons why you shouldn’t lease a car. But first, let’s cover some more of the leasing basics.

How Long Is a Car Lease?

The average car lease is usually 24, 36 or 48 months long. The most common car lease contract is 36 months (that’s three years). Most car dealerships won’t offer a lease less than two years.

How Is a Car Lease Different From a Car Loan?

Leasing and taking out a car loan are both ways to finance a car—which means you have to make monthly payments. But unlike leasing, once you pay off your car loan, you get to keep the car. Car loans are still a huge waste of money, though, because you’re paying interest the entire time—on something that’s losing value! Trust me, financing (aka debt) always costs you more—in this case thousands of dollars more.

Is There a Mileage Limit?

Yep. Most car leases limit the number of miles you can drive. If you go over that limit, you pay more. The typical mileage limit is around 10,000–15,000 miles a year. You can raise that number on the front end if you want, but that will also raise your monthly payment. And you can’t add on more miles in the middle of a car lease. So, once the lease is over, you’ll be charged a mileage penalty for every mile you drove over the limit. (Yikes. Hope you don’t have a long commute.)

Can You Make Modifications to Your Car?

It depends. You’re free to do things like add fuzzy seat covers or put a bobblehead on your dashboard. But for more permanent changes (custom paint jobs, souping up the engine or basically anything from Pimp My Ride), you’ll need to get permission from the lessor first. Remember, you don’t actually own the car—you’re just borrowing it. You’ll be expected to return the car in the same shape you got it . . . or pay the consequences.

How Does Leasing a Car Work?

In case I haven’t been clear, leasing a car is not a good idea. Now that you’ve got that down (hopefully), let’s talk about how people go about doing this—usually without realizing just how much more it’s actually costing them.

1. Choose a car.

Most people lease a car because they want to drive a sweet new ride they couldn’t afford otherwise. You might be looking at cars at your local dealership and not even think about leasing as an option until the dealer mentions it.

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Suddenly, they’ve got you picturing how cool you’ll look driving your dream car, and you can’t imagine life without it. (How have you survived this long without a heated steering wheel and massage seats?) Next thing you know, you’re signing on the dotted line of a lease agreement.

2. Finance the lease.

A car lease can come from an automobile manufacturer or a third-party lender, but it’s usually done through a car dealership. You could also technically lease a car from a private owner (also known as peer-to-peer car sharing), but you’ll have to jump through some legal and insurance hoops that are even sketchier than a normal lease.

So, how much do you have to pay to lease a car? Well, your payment is based on the residual value of the car (how much it will supposedly be worth at the end of the lease). Here are the factors that go into calculating a monthly lease payment:

  • Expected depreciation amount (how much value the car will lose over time)
  • Rent charge (aka interest)
  • Sales tax
  • Fees
  • Lease term (the number of months in the lease)

Don’t underestimate those fees, though! That’s actually where the cost really adds up. There are several fees you have to pay on the front end, including:

  • Acquisition fee (what it costs to set up the lease)
  • Documentation fee (the cost of processing paperwork for the lease)
  • Title fee
  • Registration fee

And when the lease is up, you have to fork over even more cash for things like:

  • Disposition fee (the cost of cleaning up and selling the car)
  • Excessive mileage fee (if you go over the mileage limit)
  • Excessive wear and tear fee (if you don’t maintain the car up to the dealer’s standards)

But here’s the deal: Leasing isn’t technically seen as a loan by the Federal Trade Commission. That means the dealer doesn’t have to give you the breakdown of your monthly payment like they would with a car loan. So, you’ll probably have no clue what your interest rate is or how much the lender added on top to make a profit.

And then, at the end of all that, you don’t even get to keep the car. You have to give it back to the dealer! Like I said before, leasing is the most expensive way to drive a car. And the person leasing you the car definitely comes out ahead on this deal.

3. Negotiate with the dealer.

This is really just another opportunity for the dealer to try to adjust the terms in a way that makes them more money. Also, most leases don’t require a down payment, but some dealers may want you to pay the first and last months’ payments up front.

4. Drive and maintain the car. 

This is when hypothetical you drives around flexing for your neighbors until the lease is up. But you have to make sure you keep the car in perfect condition and be careful not to go over the mileage limit if you don’t want to pay any more fees. (I don’t know about you, but I don’t need that added stress in my life.)

5. Return the car to the dealer. 

Once the very expensive joyride is over, it’s time to turn the car back in and hand over the disposition fee, along with any other fees you might’ve racked up throughout the lease period. And the worst part is, you don’t even have anything to show for all that money you spent.

Some car leases give you the option of buying the car when your lease is up. But that usually ends up costing you more in the long run. Whatever you do—don’t just trade in the car for another car lease. You already paid way more than you should have to rent the car for a couple of years. You’re better off ditching the car payment and finding a car you can actually afford.

How Does a Car Lease Affect Your Credit?

You usually need to have a “good” credit score to lease a car—around 750 or higher. And because you’re borrowing money, a car lease will show up on your credit report, just like a car loan would. Leasing a car usually drops a person’s credit score at first, but if they keep up with the payments, it’ll go back up.

Here’s the thing, though: Credit scores aren’t all they’re cracked up to be. I’m not saying you should go around trashing your credit. But when you’re slave to a credit score, you feel like you have to keep borrowing money to improve your score. And that’s a fast way to end up in a lot of debt.

You know what doesn’t require a high credit score or messing with credit at all? Buying a car with cash.

Why You Shouldn’t Lease a Car

So, by now, hopefully you can see why leasing a car is dumb. But just in case you’re still on the fence because the thought of driving around a brand-new luxury whip is hard to resist, here are a few more reasons to not lease a car:

  • Depreciation makes you lose money. All cars go down in value (or depreciate). Let’s say a fancy new car loses $20,000 in value over a two-year period (yeah, it drops real fast). If you lease it, that loss in value has to be factored into the lease payment (or the leasing company loses money). And they’re not going to set themselves up to lose money—which means your bank account gets to take that punch in the mouth instead.
     
  • It’s hard to get out of the lease early. If you get tired of a car, you can’t just return it before the lease is up—without being penalized for it, at least. You signed a lease agreement, and that baby is binding! If you want to break a car lease for any reason, you’re in for a huge, expensive headache with a lot of other fees involved.
     
  • Dealers make a ton of money on interest. Dealers can easily mark up the interest rate on a lease by a small percentage that might not seem like much to you up front, but it actually equals thousands more dollars in profit for them in the long run. In the industry, this is called dealer reserve, and like the name suggests, it benefits the dealer—not you. And again, they’re not even required to tell you how much interest they’re charging you. Sketchy for sure.
     
  • You pay more money in the long run. Dealers don’t like when you pay for a car with cash or check, because when you do, they don’t make as much profit. But it’s not your job to make them more money. It’s your job to make sure you keep more of your money! If you pay for a car with cash, you’ll end up saving a lot more. Plus, your payments will be $0 a month for forever! Now that’s a great deal.

It’s better to be wealthy than look rich. I’m all about owning nice stuff—I just don’t want your stuff to own you. And that means only buying things you can pay cash for. It pays to be more focused on the long term than the short term. You’re better off saving up for your dream car, a house or other goal, instead of getting sidetracked by a lease. Borrowing money to impress people doesn’t get you anywhere but in debt. Not caring about what other people think is a wealth-building superpower. Harness it.

How to Buy a Car Without a Lease

Don’t fall for all the hype out there. I want you to stay far, far away from leases or anything that causes you to sacrifice your long-term dreams and vision on the altar of your short-term desires. I said it before, and I’ll say it again: Buying a used car with cash is always the way to go!

Oh, and if you want to come at me with the “But George! Used cars are unreliable, and I need something safe to drive!”—save it, bucko. Do you know what your new car becomes after one week, one month, one year of driving it? A used car! If you’re buying a used car, just make sure you have it inspected by a reputable mechanic and save up to make the purchase in full and up front.

You may not be able to purchase your dream car in cash right now. And that’s okay! You start by getting a car you can afford now and then save up for a better car later. You’ll have to practice this crazy thing called patience, but you’ll be better off and less stressed when you don’t have a car payment.

Saving up for a car is a whole lot easier when you’ve got a budget. My favorite budgeting app, EveryDollar, helps me stay on track toward my savings goals. And trust me, when you’re making a plan for your money every single month and sticking to it, you’ll be able to buy a car you love sooner than you think.

Save more. Spend better. Budget confidently.

Get EveryDollar: the free app that makes creating—and keeping—a budget simple. (Yes, please.)

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George Kamel

About the author

George Kamel

George Kamel is the #1 national bestselling author of Breaking Free From Broke, a personal finance expert, a certified financial coach through Ramsey Financial Coach Master Training, and a nationally syndicated columnist. He’s the host of the George Kamel YouTube channel and co-host of Smart Money Happy Hour and The Ramsey Show, the second-largest talk radio show in America. George has served at Ramsey Solutions since 2013, where he speaks, writes and teaches on personal finance, investing, budgeting, insurance and how to avoid consumer traps. He’s been featured on Fox News, Fox Business and The Iced Coffee Hour, among others. Learn More.

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