Leasing a car can be an attractive alternative to buying one. Under the terms of a lease, a finance company purchases the car of your choice and “rents” it back to you over a specified period of time. You can return the car to any dealership and choose your next one at the end of the lease period — or buy it outright.

While this, in a nutshell, is how car leases work, let’s look at it in more detail.

The Monthly Payment

The amount you pay each month is . These include the price of the car, the amount of your down payment (capital reduction), the number of miles you agree to drive (mileage map) and the anticipated value of the car at the end of the lease period (the residual).

Basically, you’re paying for the depreciation that happens to the car over the duration of the lease. This is why the number of miles you drive and the perceived market value of the car are so critical to the process.

The “Lingo”

Leasing has its own language, as is true for other industries. We’ve already mentioned a few of the words and phrases you’ll encounter (capital reduction, depreciation, lease term, mileage cap and residual). Others include:

MSRP – the price set by the manufacturer of the vehicle

Capitalized Cost – the price of the car you negotiate with the dealer

Money Factor/Lease Rate – the interest charged by the finance company

Mileage Allowance – the number of miles you can drive the car annually

Purchase Option – allows you to buy the car outright at the end of the lease

Drive Off Fees – down payment, taxes, license fees, acquisition fees, and security deposit

Penalties/Additional Charges – come into play if you make a payment late, end the lease early or abuse the car

Disposition Fee – the amount you pay the leasing company to take the car back at the end of the lease, theoretically to cover administrative functions associated with processing the car for resale

How It All Comes Together

OK, so with all of that in mind: ?

Let’s say you’ve found the car you want to lease. The MSRP is $30,000, but you negotiate a capitalized cost of $25,000 with the dealer. The residual value is set at $12,500 and the finance company applies a money factor of .0017, which translates to a 4.0 percent loan. (Multiply the quoted money factor by 2400 to get the exact interest rate.)

Ideally, you’ll want to negotiate the lowest capitalized cost possible, the highest residual amount you can get and the lowest money factor available. As in most financing situations, the money factor is partially predicated upon your credit score. The higher your score, the lower the rate. Let’s say you’ll agree to lease the car for a period of 36 months, during which you also agree to drive a maximum of 36,000 miles.

At the end of the lease, you’ll pay for any excessive war and tear and the disposition fee. Or, you can choose to buy the car and keep it by either paying the residual value in full, or financing that amount. If you choose to return the car, you can choose another one and start the process all over again, in which case the acquisition fee and security deposit are usually waived, if you stay with the same manufacturer.

Is Leasing a Good Idea?

Coins stack in columns on saving book and car on finance concept

You may by now have observed, you’ll return the car at the end of the lease having paid $12,500 plus associated fees and you’ll need to get another car. This is why some financial experts advise against leasing. After all, you could just finance the $25,000 at the beginning of the deal and own the car outright after 36, 48 or 60 months. At that point, the monthly payments will stop and you’re just covering maintenance and the like.

On the other hand, rather than you’ll service a $12,500 debt — for the exact same car. This means your monthly payments will be much less.

If you’re handy with tools, or you choose an exceptionally reliable car, you could come out ahead financially. However, if you don’t want to be bothered with all of that, you like driving a newer car and want the security of always having warranty protection, leasing will provide you with those attributes. Further, if you use your car for business purposes, your lease payments can be tax deductible.

So, that’s essentially how car leases work.

They’re great for a lot of people, but they do have drawbacks you need to consider.