What is a Car Lease?

What is a car lease?

What does it mean to lease a car?

What is a lease?

Car leasing was designed to make cars more affordable to consumers. As prices on cars have risen, the ability for consumers to afford a loan has decreased. Enter car leasing. Car leasing allows companies to reduce the monthly payments on a car by only requiring the buyer to pay for the cost of the car during the time they are using it. It's very similar to renting - you don't own anything, you are just paying for the right to use something.

Unlike buying, however, you never actually own the vehicle and you have to return it to the bank at the end of the lease. The idea of leasing first became popular in the 1990's when cars became too expensive to buy for many people. Leasing allows a person to drive a brand new car and make lower monthly payments, thus making the "new car experience" more accessible to more people. In addition, leasing can offer tax breaks for certain occupations.

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From whom do I lease?

When you write a lease, you are typically entering into an agreement with a leasing company or a bank that has a leasing program. Most people think that they are leasing from their car dealer, but this is not true! The car dealer is NOT the leasing company!

In addition, many car manufacturers have their own leasing companies such as GMAC, Ford Motor Credit, and BMW Financial Services that specialize in creating financing programs for their own vehicles. Typically when you see an ad for financing on a certain vehicle, it's the manufacturer's finance company that is creating that special to sell more of their cars.

When you visit a car dealer and are presented with a potential lease payment, it is the leasing company that you will ultimately lease this car from. The car dealer sells the actual car to the leasing company who then turns around and leases it to you. Keep in mind that during that process the dealer is getting paid a commission from the leasing company to offer you this financing.

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Which Terms Do I need to be Familiar With?

There are 6 terms that you must be familiar with in order to understand how a lease works:

Capitalized Cost ("Cap Cost")

The capitalized cost is the purchase price of the vehicle. This will sometimes be referred to as "Cap Cost".

You may have heard of MSRP (Manufacturer's Suggested Retail Price) - this is just the list price of the vehicle to a customer. It is not necessarily what you will ultimately pay for the car, but simply a guideline to help set a precedent for what a new car is worth. Do not let the dealer tell you that the Capitalized Cost is not important in a lease - it is VERY important!

You will want to find and negotiate the lowest cap cost that you can for your vehicle, just as if you were buying your car with cash. The lower your capitalized cost, the lower your payment will be. When you finally settle on the purchase price of your vehicle, you will see this final amount represented as the "Cap Cost Reduction" - this is just the difference between what the car was offered for and what you agreed to pay for it.

Depreciation

The depreciation amount is the primary factor that determines the cost of leasing. With this in mind, it is essential to understand what it is and how it is calculated. Every year a car is in existence the value of that car drops. This is depreciation. The largest part of your leasing payment is depreciation - the cost of owning your vehicle over a fixed period of time.

When you lease a car, every year the car is worth less. Therefore the leasing company wants to make sure you pay the difference in the value of the car when you bought it from the value of the car when you turn it in. Here is an example:

Value of Vehicle

At Purchase $25,000
After Year 1 $17,500
After Year 2 $13,750
After Year 3 $10,000

Total Depreciation $15,000

As you can see, the vehicle has lost $15,000 of value over a 3 year (36 month) period. An interesting fact about depreciation is that regardless of leasing or buying, your car will still depreciate the same amount. Many salesmen will tell you that “leasing is a bad investment” – remind yourself that your car is worth the same whether you lease it or buy it. Your time may be better spent determining what vehicles are likely to depreciate the most, and opt for a vehicle that tends to hold a higher residual value.

Residual Value

The value of your car at the end of your lease is called the Residual Value. In the example above, the Residual Value at the end of three years was $10,000. When creating your lease, the leasing company predicts how much the car will be worth at the end of your lease. They do this by using industry guidebooks like the Automotive Leasing Guide (ALG) that track the value of cars at the end of their lease. Not every company uses ALG – some set their own residual prices based on their own needs.

The higher the projected residual at the end of your lease, the lower your monthly payment.

If you consider that your largest portion of a payment is the depreciation, then it is important to know how depreciation is calculated. The formula is very simple, but always starts with understanding what term you will be considering (36 months, 48 months, etc.). If you already know the residual value, the term of the lease, and the capitalized cost, you are ready to calculate your depreciation. Once you have these values in hand, the math is simple:

Capitalized Cost minus Residual divided by Lease Term.

Take a look at this example:

Factors

Capitalized Cost $25,000
Residual Value $10,000
Term 36 Months
Depreciation per Month $416.66

Let's apply this formula to the above factors:

Capitalized Cost ($25,000) minus Residual ($10,000) = $15,000

$15,000 is the total amount of depreciation over a three year period. Now simply do this:

Divide (total amount of depreciation) $15,000 by Term of Lease (36 months) = $416.66 per month

Interest Rate (Money Factor)

Most people are familiar with an interest rate but seem to be confused by a "money factor." An Interest Rate and a Money Factor are very similar! They are just represented differently.

An Interest Rate is represented as a percentage (like 6.5% interest).

A Money Factor is represented by a figure behind a decimal point (like .00250)

The way to convert a Money Factor into a comparable Interest Rate is to multiply the money factor by 2400. Therefore a Money Factor of .00250 converts to an interest rate of 6%.

Though some believe that leasing interest rates are different than automotive leasing rates, this is not necessarily true. Most "good" leasing Interest Rates are comparable to new car interest rates and in some cases lower! We will discuss finding the right interest rate in greater detail in Shopping for your Lease

Term

The Term of the lease determines how long you will lease the car for. Typically you will hear of 36, 48, and 60-month term agreements. However lease Terms can run for as few as 24 months and as long as 72 months! There are even mid-year terms such as 39-month or 42-month terms that are designed to bring customers back into the dealership during different times of the year. Customers have all kinds of reasons for choosing a short or long-term lease. Short-term lease customers typically want to change vehicles often and are willing to pay a slightly higher payment to have this option. Long-term lease customers are often willing to sign up for a long-term liability in exchange for a slightly lower lease payment.

Most popular lease terms on new cars coincide with the vehicle's warranty duration, which is why leasing is often beneficial because the car is covered under warranty for its entire term. The leasing company would prefer that you stay in the car as long as possible so they can earn as much interest during the term of the lease from you.

Taxes

Your taxes are figured differently based on which region of the country you are in. Some states choose to calculate your taxes based on the overall cost of your vehicle while others only tax the portion of your vehicle that you are leasing (the entire amount of depreciation).

Taxes are most often paid on a month-to-month basis and rolled into your payment to make them easier to pay. Because every state is different it is best to contact a local dealer or your Department of Motor Vehicles to determine how taxes are calculated in your area.

All of these factors help determine your monthly lease payment. We will discuss how your monthly lease payment is calculated later based on these factors.

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Putting Your Knowledge to Work

Understanding a mechanics of a lease is just the beginning. Throughout this website you will learn how to put leasing to work for you to lower your operating costs of a vehicle and to find the best deals in the market.

For practice, consider looking at some of the vehicle ads in your local newspaper and get a sense for how these leases are computed. Over time you will begin to immediately spot a good deal from a bad one. From time to time there are some incredible deals out there, so you should be adept at spotting them quickly and taking advantage of them.

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