An easy-to-understand guide to closed-end leases on a car.
How Closed-End Leases Differ from Open-End Leases
A closed-end lease is a commonly used rental agreement in the United States and Canada whereby the person or entity which leases an asset, typically a vehicle, from a lessor is not required to purchase the asset at the end of the lease term.
In many cases, the lessee has the option, but not the obligation, to buy the vehicle at the conclusion of the agreement. In this way, a lessee assumes no risk of the depreciation of the asset. Other names for a closed-end lease include a true lease, walkaway lease or net lease.
Closed-end leases are utilized extensively in the auto industry. Such financing transactions carry a fixed interest rate (currently averaging around 5.4%; see Figure 1) and generally run for terms of 12 to 48 months. Indeed, about a quarter of all new vehicles sold in the United States are financed via closed-end leases. See Figure 2.
Figure 1: Current Closed-End Lease Interest Rates, per WalletHub.com
Figure 2: About a Quarter of All New Vehicles in the United States are
Financed via Closed-End Lease
Source: Statista 2022
The Key First Step in a Closed-End Lease: Negotiating the Value of the Vehicle in the Transaction
For many consumers, minimizing the monthly lease payment is the key goal, but in aiming to achieve this target, one of the most important steps in reaching a fair closed-end lease agreement with a car dealer is ignored: a consumer must negotiate an agreed-upon value of the vehicle, less the value of any trade-in.
This (net) value, together with the assumed value of the vehicle at the end of the lease term, is perhaps the most important factor in the determination of the resultant monthly payment.
Phrased another way, a consumer planning to engage in a closed-end lease with a dealer must first negotiate the car’s transaction value in much the same way a traditional vehicle purchaser would.
Consumers Must Understand Mileage Limitations, Insurance and Maintenance Requirements
Another key component of a vehicle closed-end lease agreement is the maximum number of miles per year the lessee can drive the vehicle, typically 12,000 to 15,000 miles annually, without incurring specified per-mile usage charges at the end of the lease term.
Furthermore, these penalties may be tiered such that a small amount of excess mileage may carry a fairly nominal charge, while large overages entail stiffer penalty payments.
Consumers with closed-end leases are responsible to pay for the same services that owners of vehicles are. For example, a lessee generally must pay for various types of vehicle insurance, including collision coverage (with a maximum deductible set by the vehicle’s lessor), comprehensive fire and theft insurance, and liability insurance.
Frequently, lessors require lessees to take out more costly insurance policies than would otherwise be required and to specify that the lessor is a “Loss Payee” in the event of any accident. A lessee must also maintain the vehicle by making all necessary repairs and parts replacements, particularly as specified by the maintenance calendar in the car’s owner’s manual.
Figure 3 shows the key conditions of and the information an applicant must provide to secure a closed-end lease in a typical agreement.
Figure 3: Example of Terms for a Closed-End Lease Agreement
Source: Expedition Leasing
In addition, most states levy a personal tax on leased vehicles and compel drivers to register their vehicles. Many states require periodic vehicle and emissions inspections. Just as traditional car purchasers do, lessees must make and stay current on these taxes and other payments. The tax payments are based on a percentage of the vehicle’s value.
The two main components of a closed-lease monthly payment are: 1) an amount to cover the vehicle’s projected decline in value over the lease term; and 2) the rent charge, which is similar to interest on a loan.
Other Closed-End Lease Considerations and Details
Even though car dealers and/or auto finance companies are the lessors and actually own the vehicle in a closed-end lease transaction, shield laws in place in most U.S. states prevent a victim of a crash involving a leased vehicle to sue the “deep-pocketed” lessor. Instead, any liability rests with the lessee of the car and with that driver’s insurance company.
Taking out a closed-end lease can make even more sense for a self-employed worker in the U.S. who files business income and expenses with the IRS on Schedule C. The IRS allows deductibility of lease expenses for such filers.
For example, if an individual were to take out a closed-end vehicle lease with required monthly payments of $600 and uses the car 60% of the time for business and 40% for personal reasons, this individual can deduct $360 ($600 times 60%) of monthly lease expenses.
Closed-end leases are used for assets which are expected to depreciate. As a result, such structures are not used for the acquisition of raw land or real estate.
Open-End Leases: Mostly Used by Commercial Customers
A second type of lease utilized for vehicle leasing is an open-ended lease, a more flexible financing structure that frequently better fits the needs of commercial or fleet customers than individuals. Fleet customers that may need to use the vehicles for an indeterminant time frame appreciate the less specific terms entailed with such a financing option.
In an open-ended lease, also termed a finance lease, the lessee assumes all risks related to the price depreciation of the vehicle. Specifically, the lessee, at the conclusion of the lease agreement, must make a balloon payment to the lessor equal to the difference between the assumed residual value of the vehicle listed in the lease terms and its actual fair market value.
A positive aspect of the usual open-end lease is the absence of any set mileage limitations during the course of the accord (although high mileage would be reflected in the magnitude of the required balloon payment noted just above).
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Pros and Cons of a Closed-End Lease
|Not required to purchase the vehicle||Extra fees for exceeding mileage limits|
|Excessive depreciation does not affect you||Charges for wear and tear at end of lease|
Which One is Best for You?
If you are unsure whether you want to own the car after your lease term is up, consider a closed-end lease for the freedom it provides in this area.
However, if the fees that it can come with are not your cup of tea and you’re comfortable with owning the vehicle after the term is up, choose an open-ended lease.