About Car Leases

This article takes a closer look at how a vehicle lease is calculated, as well as some benefits to leasing rather than purchasing.

Misconceptions

Leasing is often thought of as just a form of long-term rental with no upside for the consumer. In reality, it can conserve cash as well as limit potential resale risk. Purchasing a vehicle provides no resale guarantee, as people who purchased gas-guzzling sport-utility vehicles are finding out. Additionally, banks are typically now requiring larger down payments on retail installment contracts. Leases can generally be written without a down payment.

Benefits

Calculating a lease is fairly simple once you have all the parameters in place. Some components of a lease can be negotiated, while others are set by the lending institution and not negotiable. Finding most lease parameters upfront is virtually impossible, so you need to be able to understand how a lease is calculated before you go into the dealership. Some dealers will be more than willing to share all the lease parameters, while others are less inclined to do so. One thing to keep in mind, though, is that most salespeople do not understand the nuances of leasing, much less how the actual payment is derived.
For the purposes of this article we will be looking at a closed-end lease that is covered under the Federal Reserve's Regulation M, which is what the vast majority of consumer leases are.

The Facts

The components of a lease are:
1) The Lessor. This is the bank that will carry the lease.
2) The Lessee. This is you, the person who is entering into a lease with the lender. A lessee usually has to have stronger credit than someone who enters into a retail purchase agreement.
3) Selling Price. The same as the selling price if you purchased the car outright.
4) Acquisition Fee. This is a fee charged by the bank to set up the lease, but it also pays for more than that. Most lease companies purchase residual value insurance, which guarantees the future resale value of the vehicle you are leasing. It is important to keep in mind primarily protects the lender, not the lessee. This residual value insurance only kicks in if the lease is carried to term, so the lessee can't use it to help you terminate a lease early. As many lessees of gas guzzlers are finding out, it does allow you to walk away at the end of a lease, in which a vehicle is worth less than the residual value. If you had purchased that same gaz guzzler, you would be the one suffering from its diminished resale value.
Most lenders also purchase gap insurance out of the proceeds of the Acquisition Fee. This protects the lessee in the event that the vehicle is a total loss and the insurance company won't cover the lease pay-off. In this instance, though, the Lessee is still responsible for their insurance company's deductible.
5) Gross Capitalized Cost. This is the total of Selling Price, Acquisition Fee and any service contracts, optional insurance products, previous negative equity or other costs added into the lease.
6) Capitalized Cost Reduction. This is any down payment amount over and above the first payment and security deposit, which are typically collected at lease signing. The capitalized cost reduction is deducted from the initial lease balance and helps to lower your monthly lease payment. In most states the capitalized cost reduction is a taxable amount.
7) Capitalized Cost. This is the initial balance of the lease and is calculated by subtracting the capitalized cost reduction from the gross capitalized cost. The capitalized cost will also include any service contracts, optional insurance products, previous negative equity or other costs added into the lease.
8) MSRP. The manufacturers suggested retail price is not reflected on the lease contract but is used to calculate the residual value of the vehicle.
9) Residual, also known as the guaranteed future value. This is the amount that the lender is amortizing the lease down to at the end of term, and what they guarantee it will be worth at that point. In a closed-end lease, the lessee has two options available at the end of term. The first is that they can turn the car back in to the leasing company and walk away after paying for any excess wear and tear or mileage. The other option is that they can purchase the vehicle for the residual amount. In this tough market many lenders will negotiate a lower buyout with the lessee if the car is obviously not worth the residual amount at the end of the lease term. This is often the case with trucks and sport utilities, although the market for compact sport utilities has been improving as of late.
10) Depreciation. This is the difference between the gross capitalized cost and the residual value. This amount divided by the term equals the average monthly depreciation, which is a component of the monthly payment.
11) Money Factor. The money factor is effectively the interest charge on the lease, although it is not represented as a percentage rate and not disclosed as such. You can get an idea of the effective interest rate by multiplying the money factor by 24. For example, a money factor of .00255 X 24 = .0612, which is effectively a 6.1% interest rate. To the get interest component of a payment, the gross capitalized cost is added to the residual and then multiplied by the money factor.
12) Total Base Monthly Payment. This is the amount you'll be paying every month before any sales or use taxes.

Function

Let's take a look at a simple lease example using an imaginary car with an MSRP of $20,000, and calculate a lease payment for a 36-month term.
The lender has decided that this car will have a residual value at the end of a three-year term that is 50 percent of the original MSRP, so the residual is $20,000 X .5 = $10,000. Their money factor is .00255.
Their acquisition fee is $495, and in this example the lessee is not going to put down a cap reduction. To keep the example simple, we will also assume that the vehicle being leased is a hot seller and is not being discounted from MSRP. There is no capitalized cost reduction or other products being added to the lease, so the gross capitalized cost and capitalized cost are the same in this example.
The first component of the payment is the average monthly depreciation, calculated by taking the capitalized cost, which in this instance is the selling price of $20,000 + acquisition fee of $495 for a total of $20,495. You subtract from that the residual value of $10,000, which gives you a total depreciation for the lease term of $10,495. Your total depreciation divided by the term $10,495 / 36 = $291.53 of average monthly depreciation. Please keep in mind that during the actual lease term, you pay more interest and less depreciation at the start of the lease and more depreciation and less interest toward the end of the lease, so you can't use the average monthly depreciation to calculate your lease pay-off during the term.
The second component of the monthly lease payment are the interest charges. To calculate those take the capitalized cost of $20,495 + the residual $10,000 and multiply the sum by the money factor of .00255. $30,495 X .00255 = $77.76.
The Base Monthly Payment will be $291.53 + $77.76 = $369.29. This amount does not include any state or local taxes that are typically added to the monthly payment, although some states require payment of taxes up front.

Expert Insight

Understanding how to calculate a lease is one thing, but finding the best lease for your ownership style is another.
Cars with better resale value will tend to have a higher residual value as well; therefore they will depreciate less during the lease term. All else being equal, a car that depreciates less will have a lower monthly lease payment.
All closed-end leases will have an annual mileage limitation. Take a realistic look at your past driving habits and have the correct number of miles per year built into the lease. A higher mileage lease will have a higher payment because the car will depreciate more during the term, but it is better to pay for those miles as you go rather than be faced with a mileage penalty at the end of the term should you go over.
While a cap reduction will lower your monthly payment, the general idea of a lease is to pay for that part of the car you are going to use while conserving your cash in the process. In most instances, I recommend against putting any cash down in the form of a cap reduction.
With the number of different lenders, lease programs and vehicles available, finding the best combination can be a daunting task. Consider using an independent leasing company to help you sort through the available programs.
Lease companies will charge for excess wear and tear at the end of the lease term, so if you have a tendency to beat up your vehicles, leasing may not be your best choice. Read the contract carefully, as most are quite specific as to what types of wear and tear they will be looking for at lease end.