Understanding the Two Types of Auto Leasing Agreements
If you’ve been considering a quote on leasing and doing research into the practice, you may have seen the terms “open-end” and “closed-end.” These are the two main types of auto leasing agreements that a lessee will sign, and each has significant differences from the other.
Before signing your agreement, it is critical to understand the difference between these two terms. Auto leasing has seen growing popularity among consumers over the last few years, and it is vital that we stay educated on the practice to get the best lease deals.
The difference between these two types of agreements is much more straightforward than it seems on the surface.
We are going to examine the differences between open and closed-end auto leases and discuss who benefits from each type of leasing agreement.
A closed-end lease is what most consumers sign. Sometimes called a “walk away lease,” this agreement allows the consumer to return the vehicle or purchase it at the conclusion of the lease.
In this agreement, the lessee is not responsible for the car’s depreciation. In other words, if the vehicle’s value is less than the dealer estimated, that’s on them.
Most non-commercial consumers prefer this because it lessens their financial risk. No matter what happens in the used vehicle market, the terms of your lease and the amount you will pay at lease end have been laid out in the agreement.
But leasing the car without taking on the financial risk of vehicle ownership does come at some cost.
For dealers to lessen their own risk, they need to be able to predict what the car’s value will be at the end of the lease term with some accuracy. This prediction is called residual value.
To make an accurate prediction, certain factors that have a significant impact on the price of used vehicles need to be assumed. For example, mileage and overall condition. You can learn more about how lease payments are calculated here.
This is why leases have mileage limits and excessive wear and tear fees. If you were allowed to drive the vehicle as much as you wanted, the residual value would be near-impossible to predict. Lessors would lose a lot of money.
So instead, the dealer assumes the risk that the car will be worth less than the residual value. You can just return the vehicle and “walk away” should that happen. In return, you promise to take good care of the car and stay under your mileage limits or pay substantial fees.
If the car is worth more than the buyout price, you can still exercise the purchase option in your agreement and get a great deal.
Unlike closed-end leases, in an open-ended lease the lessee is the one who assumes the financial risk of ownership. This means that if at the end of the lease term the vehicle’s market value is lower than the residual value, the lessee is responsible to pay the difference.
But who would want to risk owing thousands of dollars at the end of their lease? And why?
Remember that in a closed-end lease, the lessee is responsible for honoring certain conditions including mileage limits and keeping the vehicle in decent shape.
In an open-end lease, the buyer is allowed more freedom. By having the lessee assume the risk, the dealer can afford to offer them unlimited mileage limits and does not need to charge fees for excess wear and tear.
The extra depreciation resulting from these factors is the lessee’s responsibility. Therefore, the dealer doesn’t need to charge fees to offset the loss.
Open-end auto leasing is used primarily by commercial businesses.
Often times, the amount of mileage they will need to put on the vehicles to conduct their operations is very difficult to predict.
Additionally, some businesses may have their fleets operated by multiple drivers, making the final condition of the vehicle challenging to predict.
Rather than pay substantial fees in these situations, they instead take on the responsibility for paying the difference between the market and residual values.
If they choose to return the vehicle at the end of the term, and the agreement listed a residual value of $23,000, but the market value is only $17,000, they can either pay the dealer $23,000 and keep the vehicle or return it and pay the $6,000 difference.
Commercial customers are better positioned to incur these losses because they can be expensed, and companies have more flexibility with their expenses than your average consumer.
Which Type of Auto Lease is Right for Me?
If you are a regular consumer who is just looking to drive brand-new cars at low monthly costs, always go with a closed-end lease agreement. An average person electing to sign an open-ended lease is exceptionally rare.
As long as you put a typical amount of miles on your vehicle annually and are capable of taking good care of it, it’s practically a no-brainer. Be wary of any dealer attempting to convince you to sign an open-ended lease agreement.
If you are a representative or owner of a company looking to lease a vehicle or fleet, the decision is a bit more nuanced. Think about how you use your vehicle(s) and how often.
Does the nature of your operations put vehicles at risk for damage? Will they be operated by different drivers, or mostly by the same person? Is it easy to predict how many miles you will put on the car during the term? Do you have the flexibility to lease vehicles without knowing the full costs up front?
If the value of the car is lowered due to excessive mileage or damage, taking those losses will nearly always be less expensive than paying the associated fees in a closed-end agreement.
Before signing anything, know what kind of lease agreement is in front of you. It is always wise to read your lease agreement carefully, and whether it is open or closed will be stated clearly, usually at the very top of the contract.