How Car Leasing Works
Understand how car leasing works to get control of your lease deals
First, let's do away with a common misunderstanding about car leasing: car leasing is not the same as car renting. Car renting and leasing are two totally different financial concepts.
Automobile leasing is based entirely on the concept that you pay for the amount by which a vehicle's value depreciates during the time you're driving it. Depreciation is the difference between a vehicle's original MSRP value and its value at lease-end (residual value), and is the primary factor that determines the cost of leasing. The smaller the difference, the lower the lease payment, and the better the deal.
If you consider two different brand cars, both costing $30,000 when new, where one is worth $15,000 after three years and the other worth only $12,000, the first car will cost less to lease because of its smaller depreciation amount — and smaller difference between initial cost and lease-end value.
Different makes and models of vehicles can have dramatically different depreciation rates. Vehicles having the lowest depreciation make the best lease deals.
Generally, European and Japanese makes have lower depreciation than American brands. Honda, Toyota, and Volkswagen have consistently held low depreciation ratings (high resale values), as have Mercedes, Lexus, and other luxury brands. See our Lease Kit for lease ratings on all makes/models vehicles, based on expected depreciation values.
Let's take a look at MSRP and residual value, as well as the other components of leasing capitalized cost reduction, money factor and lease term to understand how car leasing works.
Manufacturer's Suggested Retail Price - MSRP
MSRP is the full price for a vehicle as displayed on its window sticker, including optional packages and destination charges. Dealer fees are not considered part of MSRP, although these charges are part of the overall cost of the vehicle.
Dealers will usually agree to discount the sticker price if you ask and you are willing to haggle for it unless the vehicle is in hot demand and low supply. See Car Price Secrets - What Dealers Won't Tell You for more details.
You can also get pre-discounted dealer prices through online new-car pricing services such as TrueCar. This service shows you what other people are paying for the car you want — and give you a low price guarantee that is often below dealer invoice price. Best of all, it's free.
Capitalized Cost (Cap Cost) - Lease Price
When you and your dealer sit down and agree on a price for a leased car, this becomes the capitalized cost, or "cap cost." In a good lease deal, the cap cost will be significantly less than MSRP. Cap cost is sometimes called lease price.
Because this is where dealers make their profit, they will sometimes imply, or possibly state outright, that price isn't negotiable in a lease, and that somehow leases are different because you aren't buying the car. This is simply not true.
It's in your best interest to always negotiate the lowest price (capitalized cost) possible a discount off the sticker price just as if you were buying. The lower your capitalized cost, the lower your monthly lease payments will be.
An easy way to get the lowest lease price (cap cost) on a car is to ask for free price quotes online from services such as TrueCar. They even give you a low price guarantee.
Capitalized cost may also include certain fees, such as an acquisition fee (similar to mortgage "points" , or loan origination fee). Acquisition fees are often not specified in lease contracts, so it may not be readily apparent that you are paying it in your capitalized cost, although it can be expected and is a normal part of a car lease.
If you haven't fully paid off the vehicle you're trading, cap cost would also include any remaining loan balance ("negative equity") after trade-in credit is applied (this is not a good practice if you can avoid it).
Capitalized Cost Reduction
Capitalized cost (lease price) can be reduced by rebates, factory-to-dealer incentives, trade-in credit, or a cash down payment. These are known as cap cost reductions. Even modest cap cost reductions, such as a down payment, can create significantly smaller monthly lease payments, especially in shorter leases.
When you subtract cap cost reductions from cap cost, you get net capitalized cost, sometimes called adjusted cap cost. This is the figure you'll use in the lease payment formula later (see Monthly Payments).
Net Cap Cost is the negotiated price of the vehicle plus any other costs minus any Cap Cost Reductions.
The wholesale worth of a car at the end of its lease term, after it has depreciated in value, is called its residual value, sometimes called "resale value." The higher the residual value, the more the car is worth at lease-end and the lower your lease payments.
Since nobody can truly predict the future, residuals are only educated guesses based on historical resale-value data for specific automobile makes and models.
Leasing companies and banks subscribe to services that provide this kind of industry data, and then use it as a basis to set their own residual numbers.
Car manufacturers' leasing companies often temporarily boost residuals on slow selling vehicles so that they can offer better lease deals. These are called subvented lease deals.
Residuals are usually stated as a percentage of MSRP. A 36-month, 50% residual on a new $30,000 car means that its estimated depreciated value at the end of a 3 year lease will be $15,000. The actual value at the end of 36 months might be higher or lower. (The Lease Kit contains estimated residuals for all current auto makes and models).
Residual percentages decrease as the length of a lease, called the lease term, increases. This is because the older a vehicle gets, the less it's worth.
For example, the 24-month residual on a particular car might be 57% of MSRP, decreasing to 50% for 36 months, then to 44% for 48 months, and 39% for 60 months.
Residuals fall rapidly in the first 24 months, then more slowly in later months. This is why shorter term leases can be more expensive than longer leases.
The best cars to lease are those whose 36-month (3 year) residuals are at least 50% of their original MSRP value.
Remember, the higher the residual, the lower the lease payments. This is not to say that cars with lower residuals cannot be good lease deals, it's just that you get more car for your dollar with the high-residual models.
Lease companies often artificially raise residual values on particular vehicles for limited-time promotions to make leasing more attractive. (See the Lease Kit for lease ratings on all vehicle makes and models). Generally, residuals set by car manufacturers' finance companies (Ford Credit, Honda Financial Services, and others) are higher than industry averages to help promote lower lease payments.
Money Factor - Lease Rate
When you lease, you're tying up the leasing company's money while you're driving their car. Remember, they spent their money to buy your car from the dealer so that they could lease it to you. They rightfully expect you to pay interest on that money, the same as with a loan.
This interest is expressed as a money factor, sometimes called lease factor, lease rate, or simply factor, and is specified as a small decimal number such as .00297. (Note: dealers will sometimes confuse you by quoting money factor as a larger decimal, such as 2.97, which means .00297, because it sounds like an attractively low annual interest rate.)
Money factor can be converted to annual interest rate (APR) by multiplying by 2400 (Yes, it is always 2400 and is not related to the length of the loan in months). For example, a money factor of .00297 multiplied by 2400 = 7.13% APR
Try converting interest to money factor, or money factor to interest, in the Converter Calculator below.
A good rule of thumb: Lease money factors, converted to APR, should be comparable to, if not lower than national new-car loan interest rates. Like interest on a loan, the lower the money factor, the lower your monthly lease payments.
Some recent manufacturers' lease deals have offered lease rates as low as .000375 (0.9% APR), or lower. However, you may not qualify for these great money factors unless if you have a spotless, or near spotless, credit rating. Credit requirements for leasing are somewhat more strict than for purchase loans because of higher risks to the financial company.
If your credit history is flawed, even if it's a mistake, you'll pay a higher money factor finance rate or not be able to lease at all. It's always advisable to know your credit score before you visit a dealer. There are actually 3 credit bureaus that report your credit. You can see all 3 bureau reports and 3 scores with a $1 seven-day trial instantly online with a simple enrollment in CreditReport.com. If you spot problems in your credit score and credit report, get them resolved with the credit agency as soon as possible. Mistakes on your credit history can haunt you for up to 10 years.
Note that money factor and interest rate are not required by law to be shown in lease contracts. So, if you want to know your lease rate, you'll have to ask — or you can calculate it using the Lease Inspector in our Lease Kit.
Lease Term (Months)
Lease term is the length of time a car is leased, usually expressed in number of months. Typical leases are 24, 36, 39, or 48 months, although "oddball" terms, such as 27, 30, and 42 months are sometimes used. These odd lease terms are generally designed to have your lease end and get you back into the showroom during a slow sales period.
Although longer leases produce somewhat lower monthly payments (see interactive graphic at right), it may be smarter to choose a shorter lease term. Here's why.
Choose a lease term that's no longer than the general coverage ("bumper-to-bumper") warranty (not "drive train" warranty) that comes with your vehicle. That way, you're covered for the entire duration of the lease if something breaks. For example, if a vehicle's "bumper-to-bumper" warranty is 36 months, don't lease for longer than 36 months.
Many major vehicle problems start in the fourth or fifth year. For this reason, 60 month leases, which are declining in popularity, are not recommended except for those few brands that have unusually long warranties (Hyundai: 5 years).
Understanding how car leasing works is essential to being able to lease intelligently and getting the best deals.