Thousands of people lease cars every year but only a small percentage understand how leasing really works. In fact, leasing is often misunderstood to the point that it is often considered a scam or evil plot on the part of car dealers.

Leasing is actually a simple concept and one that has been around in the commercial equipment business for 75 years or more. However, consumer leasing of automobiles has only been popular since the 1970's. As car prices increase, the interest in leasing increases because it offers a less expensive way to drive the car that a consumer would not otherwise be able to afford.

Car leasing is a way to finance the use of a vehicle over a period of time. It's similar to renting, but not quite the same thing. With leasing, you pay for two things: (1) expected depreciation in value of the vehicle over the life of the lease, based on the number of miles you expect to drive, and (2) finance charges that amount to interest on the money that the lease company has spent on the purchase of the vehicle. The lease company is "lending" you the money they have tied up in the vehicle. The longer you drive their vehicle, the longer their money is tied up and can't be used for other purposes, and the more you pay in finance charges.

Let's assume, to keep things simple for the time being, that you lease a $25,000 vehicle that will not depreciate in value over the life of the lease, regardless of the number of miles driven. The vehicle will be worth as much at the end of the lease as at the beginning $25,000. This is not realistic, but let's go along with it for now.

In this case, you will pay nothing for depreciation. If this was the only thing you paid for in a lease, this lease would be free. However, the lease company spent $25,000 to buy the vehicle and lease it to you. They are actually loaning you the vehicle and loaning you the $25,0000 so that you can drive their car. Therefore, they expect you pay them interest on that loan, which is how they make their money. This is like any loan, credit card account, or home mortgage.

Since you only pay interest on a leased car, leases are actually like interest-only home mortgages, which have been exploding in popularity in the last few years. You don't pay any on the principal to reduce the amount you owe. You only pay the loan company for the use of their money.

In our ideal car leasing situation, you pay interest (called "money factor" or "lease factor") on the entire value of the car for the life of the lease. In our example, this is $25,000. If the lease term is 3 years, you pay interest on this amount every month for three years, and then return the car to the lease company, which is the same as repaying the principal on your loan. This ends the lease.

Now, in real life, leases are a little different than our "ideal" lease. All cars depreciate in value from the moment they are driven off the dealer's lot. The more miles they are driven, the less they will be worth at the end of the lease. This means that our $25,000 car will only be worth, say, $13,000 at lease-end. Therefore, when you get to the end of your lease and return your car to the lease company, you are only repaying the lease company $13,000 of the orginal $25,000 that you "borrowed" from them. Over the life of the lease, you must, therefore, not only pay interest as described above, but also pay for the $12,000 that was lost as a result of depreciation. If you drove more miles than expected, or damaged the car, it's value has depreciated even further, and you are expected to pay for that as well.

In summary, leasing is simply an alternative method of financing the use of an automobile. It makes perfect financial sense. However it is frequently misunderstood and declared as an evil plot by dealers to take customers' money. This is not to say that leasing is the right choice for all automotive consumers. It's not. It's also not to say that dealers don't take advantage of customers' lack of knowledge about leasing. They do. This is why automotive consumers should take the time to learn about leasing, how it works, and how to spot dealer abuses. LeaseGuide.com is a good starting point.