Closed-end leasing
Encyclopedia
Closed-end leasing is a contract
-based system governed by law
in the U.S.
and Canada. It allows a person
the use of property
for a fixed term, and the right to buy that property for the agreed residual value
when the term expires.
Closed-end leases are so called because they run for a fixed term, and the lessor and lessee agree in the lease contract what the residual value of the property being leased will be. In most cases (particularly in retail motor vehicle
leases), the lessee has an option to purchase the property for the agreed residual value at the end of the lease term. Closed-end leases are not used for property which increases in value.
In most cases, when a closed-end lease is entered, the lessor does not already own the property being leased. Rather, the lessor agrees to purchase the property for a certain amount (the "capitalized cost") from a third party, such as a car dealer
. The lessee will often be required to offer money up front as an offset against the capitalized cost (this is called the "capitalized cost reduction" although it is sometimes erroneously referred to as a "down payment"). The difference between the (adjusted) capitalized cost and the residual value is the depreciation
component of the lease cost. In addition to depreciation, the lessee must also pay the lessor's cost of financing the purchase of the vehicle, which is referred to as "rent
"; the rent also includes the lessor's profit.
The total lease cost can either be paid in a single lump sum
, or amortized
over the term of the lease with periodic (usually monthly) payments.
Closed-end leases generally provide that the lessee is responsible for insuring the property, for maintaining it in accordance with the lessor's requirements, and for paying any tax
es or license fees which may be assessed on the lessor as owner of record. Motor vehicle leases generally include a provision for determining the amount of "excess wear and tear
" (or "wear and use") at the end of the lease term, for which the lessee is responsible upon returning the vehicle.
Closed-end leases have become very popular for automobile buyers in North America
since the mid-1980s. Shield laws in most states allow lessors to avoid legal responsibility
for the actions of their lessees, which has made it practical for automakers to offer leases direct to consumer
s without fear of "deep pocket
s" liability
for injuries resulting from an accident
. In those states which assess a use tax
on vehicles, lessees need only pay tax on the amount of their lease payment, not on the entire value of their vehicle at the time of purchase. Finally, and most significantly, because lessees pay only for depreciation and financing, and not the entire retail cost of the vehicle, payments can be significantly lower than in loan
-based financing. This allows consumers to significantly shorten their purchase cycle, increasing new-vehicle sales, which gives the automakers reason to emphasize leasing programs in their marketing
.
Closed-end leases are not always the best choice for consumers. The finance companies
which offer consumer car leases frequently require lessees to hold more-costly insurance policies
than would otherwise be necessary. Automakers often view leasing as a sales tool, and artificially inflate the lease-end residual value; this can make exercising the purchase option at the end of a lease more expensive than simply financing the vehicle over the longer term in the first instance. Finally, because of the increased financial risks undertaken by the lessor, higher credit quality is generally required to enter into a lease than to purchase a vehicle.
Contract
A contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...
-based system governed by law
Law
Law is a system of rules and guidelines which are enforced through social institutions to govern behavior, wherever possible. It shapes politics, economics and society in numerous ways and serves as a social mediator of relations between people. Contract law regulates everything from buying a bus...
in the U.S.
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
and Canada. It allows a person
Person
A person is a human being, or an entity that has certain capacities or attributes strongly associated with being human , for example in a particular moral or legal context...
the use of property
Property
Property is any physical or intangible entity that is owned by a person or jointly by a group of people or a legal entity like a corporation...
for a fixed term, and the right to buy that property for the agreed residual value
Residual value
Residual value is one of the constituents of a leasing calculus or operation. It describes the future value of a good in terms of percentage of depreciation of its initial value....
when the term expires.
Closed-end leases are so called because they run for a fixed term, and the lessor and lessee agree in the lease contract what the residual value of the property being leased will be. In most cases (particularly in retail motor vehicle
Motor vehicle
A motor vehicle or road vehicle is a self-propelled wheeled vehicle that does not operate on rails, such as trains or trolleys. The vehicle propulsion is provided by an engine or motor, usually by an internal combustion engine, or an electric motor, or some combination of the two, such as hybrid...
leases), the lessee has an option to purchase the property for the agreed residual value at the end of the lease term. Closed-end leases are not used for property which increases in value.
In most cases, when a closed-end lease is entered, the lessor does not already own the property being leased. Rather, the lessor agrees to purchase the property for a certain amount (the "capitalized cost") from a third party, such as a car dealer
Car dealership
A car dealership or vehicle local distribution is a business that sells new or used cars at the retail level, based on a dealership contract with an automaker or its sales subsidiary. It employs automobile salespeople to do the selling...
. The lessee will often be required to offer money up front as an offset against the capitalized cost (this is called the "capitalized cost reduction" although it is sometimes erroneously referred to as a "down payment"). The difference between the (adjusted) capitalized cost and the residual value is the depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
component of the lease cost. In addition to depreciation, the lessee must also pay the lessor's cost of financing the purchase of the vehicle, which is referred to as "rent
Renting
Renting is an agreement where a payment is made for the temporary use of a good, service or property owned by another. A gross lease is when the tenant pays a flat rental amount and the landlord pays for all property charges regularly incurred by the ownership from landowners...
"; the rent also includes the lessor's profit.
The total lease cost can either be paid in a single lump sum
Lump sum
A lump sum is a single payment of money, as opposed to a series of payments made over time .The United States Department of Housing and Urban Development distinguishes between "price analysis" and "cost analysis" by whether the decision maker compares lump sum amounts, or subjects contract prices...
, or amortized
Amortization (business)
In business, amortization refers to spreading payments over multiple periods. The term is used for two separate processes: amortization of loans and amortization of intangible assets.-Amortization of loans:...
over the term of the lease with periodic (usually monthly) payments.
Closed-end leases generally provide that the lessee is responsible for insuring the property, for maintaining it in accordance with the lessor's requirements, and for paying any tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
es or license fees which may be assessed on the lessor as owner of record. Motor vehicle leases generally include a provision for determining the amount of "excess wear and tear
Wear and tear
Wear and tear is damage that naturally and inevitably occurs as a result of normal wear or aging. It is used in a legal context for such areas as warranty contracts from manufacturers, which usually stipulate that damage due to wear and tear will not be covered.Wear and tear is a form of...
" (or "wear and use") at the end of the lease term, for which the lessee is responsible upon returning the vehicle.
Closed-end leases have become very popular for automobile buyers in North America
North America
North America is a continent wholly within the Northern Hemisphere and almost wholly within the Western Hemisphere. It is also considered a northern subcontinent of the Americas...
since the mid-1980s. Shield laws in most states allow lessors to avoid legal responsibility
Obligation
An obligation is a requirement to take some course of action, whether legal or moral. There are also obligations in other normative contexts, such as obligations of etiquette, social obligations, and possibly...
for the actions of their lessees, which has made it practical for automakers to offer leases direct to consumer
Consumer
Consumer is a broad label for any individuals or households that use goods generated within the economy. The concept of a consumer occurs in different contexts, so that the usage and significance of the term may vary.-Economics and marketing:...
s without fear of "deep pocket
Deep pocket
Deep pocket is an American slang term; it usually means "extensive financial wealth or resources". It is usually used in reference to big companies or organizations , although it can be used in reference to individuals .In the context of a lawsuit, the deep pocket is often the target defendant,...
s" liability
Legal liability
Legal liability is the legal bound obligation to pay debts.* In law a person is said to be legally liable when they are financially and legally responsible for something. Legal liability concerns both civil law and criminal law. See Strict liability. Under English law, with the passing of the Theft...
for injuries resulting from an accident
Car accident
A traffic collision, also known as a traffic accident, motor vehicle collision, motor vehicle accident, car accident, automobile accident, Road Traffic Collision or car crash, occurs when a vehicle collides with another vehicle, pedestrian, animal, road debris, or other stationary obstruction,...
. In those states which assess a use tax
Use tax
A use tax is a type of excise tax levied in the United States. It is assessed upon otherwise "tax free" tangible personal property purchased by a resident of the assessing state for use, storage or consumption of goods in that state , regardless of where the purchase took place...
on vehicles, lessees need only pay tax on the amount of their lease payment, not on the entire value of their vehicle at the time of purchase. Finally, and most significantly, because lessees pay only for depreciation and financing, and not the entire retail cost of the vehicle, payments can be significantly lower than in loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
-based financing. This allows consumers to significantly shorten their purchase cycle, increasing new-vehicle sales, which gives the automakers reason to emphasize leasing programs in their marketing
Marketing
Marketing is the process used to determine what products or services may be of interest to customers, and the strategy to use in sales, communications and business development. It generates the strategy that underlies sales techniques, business communication, and business developments...
.
Closed-end leases are not always the best choice for consumers. The finance companies
Consumer finance
Alternative financial services in the United States refers to a particular type of financial service, namely sub-prime lending by non-bank financial institutions. This branch of the financial services industry is more extensive in the United States than in some other countries, because the major...
which offer consumer car leases frequently require lessees to hold more-costly insurance policies
Insurance contract
In insurance, the insurance policy is a contract between the insurer and the insured, known as the policyholder, which determines the claims which the insurer is legally required to pay. In exchange for payment, known as the premium, the insurer pays for damages to the insured which are caused by...
than would otherwise be necessary. Automakers often view leasing as a sales tool, and artificially inflate the lease-end residual value; this can make exercising the purchase option at the end of a lease more expensive than simply financing the vehicle over the longer term in the first instance. Finally, because of the increased financial risks undertaken by the lessor, higher credit quality is generally required to enter into a lease than to purchase a vehicle.