How Leasing a Car (and Getting Out Early) Works
Laura answers a listener question about how to get out of a car lease early. Find out how leasing a car works, what to do if you need to exit one before it expires, and how leasing compares to buying a vehicle.
Laura Adams, MBA
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How Leasing a Car (and Getting Out Early) Works
A Money Girl Podcast listener named Alexandra says, “I’m leasing a car that costs $425 per month and I have 22 months left before the lease expires. But this expense is taking a toll on my budget. I’m underwater and the dealer suggested getting a loan to purchase the car for $20,000. Is this the best option to get out of my car lease early?”
I’ll answer Alexandra’s important question and explain how leasing a car works. You’ll find out how it compares to buying and what to do if you need to get out of a car lease before it expires.
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What’s the Difference Between Buying and Leasing a Car?
Almost a third of all consumers choose car leasing instead of buying. I joined them this year when I leased my very first car: a 2015 Fiat e500. The “e” stands for electric and I’m also ecstatic about it because it’s really fun to drive and I never have to pump gas, just charge it at home or while I’m shopping.
First, I want to make sure you understand the fundamental difference between buying and leasing a car. When you get an auto loan you finance the purchase of a vehicle and with a lease you finance the use of one over a set period of time.
When you purchase a car with a loan, you finance the price of the vehicle less any down payment that you make. For instance, if you buy a $25,000 car and make a $5,000 down payment, you make up the difference by borrowing $20,000.
You can get a car loan from banks, credit unions, or local or online lenders, such as:
- Upstart
- LightStream
- Prosper
- Lending Club
Your monthly payments are determined by the interest rate and length of the loan. Let’s say Alexandra borrows $20,000 at a 3% APR (annual percentage rate). If she gets a three-year loan, her monthly payment would be about $580.
That wouldn’t help her situation because it’s more than her current $425 lease payment. But if she got a 5-year loan instead, her payment would be close to $300, allowing her to save $125 per month.
While that lower payment sounds great, the longer your loan term, the more you pay in interest. Alexandra would pay almost $2,000 in interest over 5 years, while a 3-year loan would only cost about $940 in interest.
Plus, longer auto loans make it easier to get “upside down,” where you owe more than the vehicle is worth. That means if you want to sell the car or if it gets stolen or totaled in an accident, you might have to pay extra money out-of-pocket to make up the difference.
Some benefits of financing a car are that you can customize it, drive it as much as you want, and even drive it for years after you’ve paid it off. You can sell it or trade it in for its resale value at any time before or after you pay off the loan.
But the main downside is that you’re responsible for all major repairs after any warranty that you may have expires. While my example shows that Alexandra could potentially save money buying the car, she’ll be taking a risk that it won’t need any expensive repairs before it’s paid off. That could easily wipe out the savings she’s trying to achieve.
See also: 5 Ways to Get a Loan with Bad Credit
How Leasing a Car Works
Instead of paying for the entire car, you only pay for the estimated depreciation of the car during the time you lease it.
On the other hand, when you lease a car, you’re actually financing just a portion of the vehicle’s price. This portion is the estimated amount of depreciation that you’ll use up during the lease term.
Let’s say you lease a $40,000 car that will be worth $20,000 in three years when your lease expires. This $20,000 in depreciation, less any trade in or down payment plus dealer fees, is the basis for the calculation of your monthly lease payments.
This is why lease payments can be much lower than loan payments for the same vehicle. Instead of paying for the entire car, you only pay for the estimated depreciation of the car during the time you lease it. At the end of the lease term you can return the car or purchase it at a depreciated resale value.
Leasing can be attractive because you get to drive a newer or high-end vehicle, for a lower monthly payment, when compared to the cost of buying it for the same price and down payment. Even if you purchase a car using a low or no-interest loan, leasing is usually less expensive in the short term.
And as I mentioned, a major advantage of leasing is that you don’t have to deal with major repairs because most are covered if you get a lease term that lasts just as long as the manufacturer’s warranty.
Disadvantages of Leasing a Car
While there are plenty of upsides to leasing, it comes with downsides as well. A biggie is that you’re typically charged a mileage fee if you drive more than 10,000 to 12,000 miles per year. Depending on your work and lifestyle, maintaining low mileage may not be possible.
Another huge issue is Alexandra’s dilemma: what happens if you need to get out of a car lease early? You might sign a lease in good faith, but then have a financial hardship or a major life change that doesn’t make the car a good fit for you anymore.
You could lose your job and have trouble making payments. You might take a new job that requires you to drive more miles and exceed the annual mileage cap. Or you might need a minivan because twins are on the way.
If you own a car, it’s no problem to sell it or trade it in for a new one—even if you have a loan. But breaking a car lease is more restrictive and can be expensive.
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Ways to Get Out of a Car Lease Early
First, review your contract and speak to the dealer so you understand the full cost of breaking a car lease. Here are 3 options to consider if you need to get out early:
Option #1: Return the Car
Returning the car to the dealer before the end of a lease should be your very last resort. Even if you give it back or ask for a voluntary repossession, you’re still on the hook. The early termination fees and penalties could be just as much as sticking with the agreement.
If you don’t make lease payments, it will damage your credit, just like defaulting on a car loan would, so I definitely don’t recommend this option. If you have to pay for the car, you might as well keep it and use it.
Free Resource: Credit Score Survival Kit—a multimedia tutorial with smart strategies to build and maintain excellent credit for life!
Option #2: Buy the Car
Whether you should buy a car during a lease or at the end of the term depends on what price the dealer offers you. If the vehicle’s market value is higher than the price, buying it might be a good idea.
But if the car is really worth less than what the dealer asks, it’s obviously a bad idea to buy it. And this is what Alexandra means by being underwater. The value of the car is less than what she owes on the lease.
So if Alexandra buys the car, it could wipe out all of the savings she hoped for by choosing a lease in the first place. You can research vehicle prices and depreciation rates on sites like:
Option #3: Transfer Your Car Lease
You can even transfer a car lease to someone who lives in a different state if you or the buyer arrange to have the vehicle delivered by a car carrier service.
Transferring your car lease is the best option, but isn’t always a slam-dunk. It’s also called a lease trade and a lease assumption. It’s very affordable and doesn’t hurt your credit, so is the best solution for Alexandra.
A lease transfer is when one person takes over the payments of a leased vehicle with the approval of the leasing company and assumes all the rights and responsibilities of the original agreement. The person with the lease is called the seller and the person who wants to assume the lease is called the buyer.
Sites like leasetrader.com and swapalease.com allow you to advertise your vehicle and lease to prospective buyers. People who want to get out of a lease are matched up with people who want to take over a lease for the remainder of the term.
Lease trade sites walk you though the process and help you legally exit your agreement. When someone wants to take over your lease, you transfer ownership and the new owner makes all the future payments. Lease sellers walk away with no financial penalties.
Listing a leased vehicle online doesn’t guarantee that you’ll find someone to take it. But there are usually many people in the market for short-term, no-down payment, affordable car leases. You can even transfer a car lease to someone who lives in a different state if you or the buyer arrange to have the vehicle delivered by a car carrier service.
There are some leasing companies that may not allow transfers or may require the seller to retain some liability for the vehicle even after the transfer. For instance, if the buyer didn’t pay their excess mileage charges or a lease-end fee, some leasing companies could ask you to pay them. It varies depending on the leasing company, the manufacturer, and the state where you live.
Lease trading sites do charge advertising costs and transaction fees associated with doing a transfer; however, it will be much less than buying out your lease and paying an early termination penalty. Plus, the lease buyer typically pays the bulk of the transfer costs.
So be sure to find out what’s allowed under your existing contract. That’s an important tip to consider before you sign a new lease. If your leasing company allows transfers, you’ll have much more flexibility if you need to get out early.
Also remember that the primary factor that determines the cost of a car lease is the depreciation that’s expected to happen during the term of the lease. Different makes and models depreciate at different rates. So the best lease deals can potentially be found for models with the lowest depreciation rates.
Free Resource: Online Loan Comparison Chart (PDF download)
Should You Buy or Lease a Car?
Leasing means having little or no equity with lower payments. And buying means having partial equity with higher payments.
Unless you live in a large metropolitan area with plenty of public transportation or car sharing services, having a vehicle is an expense that most of us have to bear. So what’s better: buying or leasing?
Leasing means having little or no equity with lower payments. And buying means having partial equity with higher payments.
Leasing a car is similar to buying in that it’s usually a losing proposition, financially speaking. A car depreciates the same amount whether the driver owns it or leases it. While it’s possible to come out ahead with some remaining equity in a leased vehicle, you typically don’t.
If you like the benefits of leasing, it offers a more carefree lifestyle where you don’t have the headaches of ownership. But if long-term cost savings is your primary objective, then you should buy a car and drive it until the repair costs begin to exceed the cost of replacing it.
Once your loan is paid off, keep sending the same amount of money to a savings or retirement account. That’s generally the best way to save money—unless you have a good investment plan for the money you could save by leasing.
For instance, if you compare the cost of buying versus leasing a car and find that you’d save $200 per month with a lease, consider the opportunity cost. If you invest the $200 savings over 36 months at 8% interest, that could give you over $8,000 by the end of the lease.
So what’s right for you will depend on your financial situation and personal preferences. If you can’t afford the higher payments of a car loan, consider buying a less expensive model or a reliable used car. Before leasing my Fiat, I always purchased pre-owned cars instead of new ones.
But if low monthly payments and the opportunity to drive a new vehicle every few years with little hassle is worth the extra cost, leasing is the way to go. Just be sure that you can live with the limitations on mileage and have enough income or emergency savings to afford the lease for the entire term.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.