How to Read Your Motor Vehicle Lease
… and how to know if you’re getting a good deal on financing your new car.
Note: this is the 2nd of a 3-part series on buying versus leasing a new car. Part 1 is here:
There are several advantages to leasing a new motor vehicle, compared with purchasing, but the advice that you get from most finance writers and dealer finance departments is really bad.
The fact is that whether to buy or lease a motor vehicle is one of the most complicated financial decisions that any consumer might face. It’s so complicated, and difficult to decode, that some people simplify the decision by reducing it to a moral choice, rather than a financial. You might hear people say, “Never buy a used car; always buy used.” Or you might hear, “Always pay cash,” or “Never, ever lease,unless you’re one of those idiots that has to drive around in a new car every three years.”
If one of those pithy aphorisms applies to you, then stop reading right now, because this column is only for the people that already know they want to drive a new car, and they want to find the least expensive way to finance it. Because leasing is an option, this column will help those in the market for a new car understand how to read their complicated lease agreement.
The vocabulary of leasing is different from that of buying, for good reason. Because when you lease, you are not purchasing a vehicle, it isn’t proper (or legal) to use words like “price” (because there is no sale of the car), or “loan” or “interest rate” (because there is no debt). A lease is an agreement to rent a car for an extended period of time — usually more than two years and less than four.
Nonetheless, it help to understand the vocabulary of leasing if we know which leasing terms are analogous to the purchase terms, because most of us already know how to think of the vocabulary of purchasing, and in many cases, we can make a direct translation.
For example, instead of “price,” your lease agreement will say, “Agreed Upon Value of The Vehicle.” This is what you, the dealership, and the leasing company all agree that the vehicle would be worth if you were going to purchase it. Added to this amount might be additional amounts that the leasing company agrees to finance for you, such as the first monthly payment, the title and registration fees, or any other dealer fees. For example, in the YouTube video example above, there is a mysterious $5 postage charge added to the Agreed upon Value of The Vehicle to calculate the Gross Capitalized Cost.
Before we compute your monthly payments, we have to subtract everything from the Gross Capitalized Cost that helps you pay for the vehicle, including the value of any trade-in, the value of any special rebates or incentives, and the value of any dealer concessions (i.e., discounts), or any payments that you make up front simply because you want your monthly payment to be lower. In a purchase, these upfront payments can be called a “down payment,” but in leasing, they are called Amount Due At Lease Signing or Delivery. The Adjusted Capitalized Cost is value of the vehicle, minus all these payments or credits that reduce your monthly payment. In the purchase, this would be called the “amount financed.”
One of the biggest differences between leasing and buying is the way that the monthly payments are calculated. In a purchase, you pay principal and interest on your loan, until your debt goes at the end of the loan term. But in leasing, you pay only the Depreciation and the Rent. This is why payments for a lease are always lower than for a purchase, and it sometimes causes people to buy more expensive cars than they can really afford. (Please don’t fall for this trap. Decide on the car first, and then choose the least expensive finance option. Avoid cars that you can’t afford to purchase, even if your monthly budget would allow you to lease).
The Depreciation is the loss in market value of the vehicle over the life of the lease. As cars get older or are driven more miles, they lose value. The leasing company owns the car (not you) and they will suffer the expense of this loss of value (called depreciation). They expect you to pay them for that expense.
Depreciation is calculated by subtracting value of the car at the end of the lease from the Agreed Upon Value of the Vehicle.
But how does anyone know what the value of the car will be after 42 months?
No one does. Not you. Not the dealer, and not the leasing company.
So instead of waiting 42 months to see what that used car value turns out to be, the leasing company makes an assumption. In the video above, they assume the car will be worth $12,325 at the end of the lease term, and they call this the Residual Value.
The Residual Value is important for two reasons:
- It is the basis for calculating the Depreciation, which is the biggest part of your monthly payment. The higher the Residual Value, the lower your monthly payments.
- If you choose to purchase the car from the leasing company at the end of the lease, they will sell it to you for the Residual Value.
This last point is where too many people get confused about leasing, and it is the biggest advantage of leasing over buying. (The second biggest is deferring your sales tax payments).
The biggest advantage to leasing is the value of the option you have to purchase at a fixed price years later.
Because the leasing company agrees to the price at the beginning of the lease, but you don’t have to make your decision about a purchase until the end of the lease, you will have a big information advantage over the leasing company. If the car is worth more than the Residual Value in 42 months, you might decide to buy it at the Residual Value and lock in immediate equity. But if the car is worth less, than you simply put the car back to the leasing company and let them take the loss of the extra depreciation.
The second important component of the monthly payment when leasing is the Rent, and this is determined from the Adjusted Capitalized Cost. The leasing company is expecting a return on the investment they’ve made in the vehicle you’re driving, and the rent is the how they earn that return. The higher your rent, the greater their return. The video shows you how to calculate the rent as an annualized return on investment for the leasing company by diving the rent by the Adjusted Capitalized Cost and doing some exponential algebra. Compare the answer you get from these calculations to the interest rate offer by your bank on the loan you would use to purchase the vehicle. If the rent expressed as an equivalent interest rate you calculated with the method in the video is lower than the interest rate in your loan offer, than leasing is a better deal.
If exponential algebra isn’t you think, then ask your dealer finance rep to tell you the Money Factor on the lease. That’s the constant that the finance reps are using to calculate the rent. Multiple the Money Factor by 2400 to convert it to an equivalent interest rate, and then do the comparison. Some states require disclosure of the Money Factor, others don’t.
Another way to know whether the lease is a good deal is to compare the Residual Value with the Agreed Upon Value of the Vehicle. You will discover that, after 42 months, the leasing company will offer the Subaru Impreza quoted in the video at 65% of the Agreed Upon Value of the Vehicle. That’s very high, compared to most lease offers, and it means the depreciation used to compute your monthly payments will be very low (compared to offers with lower Residual Values). Keep in mind that the higher the Residual Value, the more used car market risk the leasing company accepts, and the less risk you accept. So a high residual percentage and a low-interest rate are the indications of a good lease financing deal.
There are a couple other factors that go into reading your lease. For example, the leasing company guarantees the Residual Value, and the expect you to guarantee that you won’t drive the vehicle for more miles than the lease allows. In our video example, that’s 15,000 miles/year. Go over that amount at the end of the lease, and you’ll either have to buy the car (at the Residual Value price), or pay the leasing company an additional 15 cents/mile to compensate them for the additional depreciation.
But the second most important advantage of leasing is the tax savings. In most states, because there is no purchase, there is no sales tax. That is, you only pay sales tax on the monthly payments, not on the purchase price of the vehicle. When you buy a car, the full purchase prices are taxed. Even when those taxes are financed in your monthly payment, the taxes will be paid up front and added to the balance of your car loan. But with leasing, the taxes are paid only on the depreciation and rent, and only when the monthly payments become due. So in these states, you get to reduce and delay the amount you pay in taxes by leasing (compared to buying).
Note that if you do decide to purchase the car at the end of the lease, you’ll pay the sales tax on the residual value. This purchase option will almost always result in a higher monthly payment, and you will be financing a used car, rather than a new one, which means that the bank you borrow from is likely to offer you a loan at a higher interest rate. But the option value and tax deferment will more than makeup for the increased borrowing costs. Besides, if you’re disciplined, you’ll use the money you saved in monthly payments during the 42 month lease period to pay down credit cards, or other debt, or you’ll save for a down payment at the end of the lease period to reduce your borrowing costs.
I’ve created a much more mathematical, complex, treatment of the comparison between leasing and buying in a 4-part YouTube playlist that instructs my engineering students how to draw cash flow diagrams and do financial calculations. I’ve summarized the shortcuts in this post, and provided links to the more complicated videos for those who are curious.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions