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 Car Leasing is a topic that we use to supplement our car buying topic. That's because the same people that are thinking about buying a car are often wondering if leasing a car is a better choice. In this article we are going to discuss what goes into the calculation of car leasing payments. This way if you're thinking about getting a new car, this article might help you make a more informed choice.
Lease or Buy a Car?
We have discussed at length a process you can use to help choose the right car to suit your needs in our article on Automobile Purchase. When you have finally gone through that process you will be faced with one final decision - lease or buy?
The popularity of car leasing has risen dramatically in recent years. Just think about all of the commercials you've seen on television or heard on the radio talking about inexpensive monthly car lease payments. And while automobile dealerships might be celebrating the success of this approach as a consumer you need to make sure you are making an informed decision.
Understanding Car Lease Payments
To understand how a dealership might calculate their car lease payments, you need to think about a car as an asset. Like many other assets, a car's value goes down over time as the useful life of the car gets shorter. In other words, the car is subject to depreciation in value over time.
Everyone recognizes that a used car with 100,000 miles on the engine is worth less than it was when it was first purchased - the market value of the car has gone down. The wear and tear that a car undergoes as it is driven simply lowers the market value of the car - since the total number of miles a vehicle can be driven is considered finite or limited.
Calculating Lease Payments
When a car dealership sets up a car lease, they are using a lot of historical data to project the market value of the car at the end of the lease. For example, let's look at a car that is worth $25,000 when new and its value after a three year lease has expired. The car dealership has a pretty good idea what a car of given make and model is worth when it is three years old and has around 36,000 miles on it. For a car in that condition, let's assume the market value is roughly $10,000.
Car Lease Example
So in this example, the capitalized cost of the car is $25,000 and its residual value is $10,000. This means that the leasing payments need to cover the $15,000 decline in value of the car over the lease term plus interest expense and leasing fees.
One way that companies are able to provide lessees with low monthly lease payments is through a mechanism that is referred to as capitalized cost reduction. Essentially, this is an up-front payment that "prepays" some decline in the car's value. It's very similar to the concept of what happens when you've got a car loan and make a down payment.
Going back to our example, let assume that the lease requires a capitalized cost reduction payment of $5,000. This means you will need to make a $5,000 payment at the beginning of the lease. It also means that the monthly car lease payments only have to cover the $15,000 decline in the car's value minus the $5,000 paid upfront - which is equal to $10,000.
Car leases typically include other upfront fees and security deposits and the money you're borrowing on the lease is subject to an interest expense which is known as the money factor.
Mileage Charges
Mileage is also worth a quick mention in this example. We assumed that the car would have 36,000 miles on it when returned to the leasing company. This assumption was based on a limit, or mileage cap, of 12,000 miles each year. The mileage on a car has a lot to do with its value, so leasing companies set an annual limit on mileage.
If the car has more than the mileage limit when returned to the leasing company, you will likely have to pay a mileage charge to compensate the dealership for the car's lower value.
Car Lease Calculators
If you'd like to see all of these factors at work, you should read through our article on car lease calculators. There you'll find a detailed explanation of how a monthly car lease is calculated along with a lease spreadsheet that you can download for free.
Online Car Lease Calculators
If you're looking for an online tool that you can use to run through some car lease payment scenarios, then you might want to take a look at our auto loan calculator section. There you'll find a wide array of car loan and lease tools including an online car lease calculator.
Car Leasing Tips
This is a good place to stop because now that we know exactly how leasing companies calculate lease payments and you also know where to go to find tools to help you perform the calculations yourself.
So we're going finish up this article with a couple of car leasing tips:
- Always negotiate the lowest possible price on a car because this is the same as the capitalized costs that is used to calculate the monthly lease payment. The lower the capitalized cost, the lower the monthly payment. A good car lease will offer a capitalized cost that is less than the Manufacturer's Suggested Retail Price or MSRP.
- The best cars to lease are those that hold their value well. If the residual value on the car is high after the lease is over, then the monthly payments can be lower. This is the rationale behind the suggestion that leasing luxury cars is a good deal. Luxury cars tend to be well-built cars that have high residual value.
- Don't judge a car lease offer just by the monthly payment. Take a careful look at all of the costs associated with the lease, in particular a capitalized cost reduction payment.
- If you drive a lot of miles each year, you need to pay special attention to the mileage charge associated with the lease. These additional payments can add considerably to the effective monthly cost of the lease.
About the Author - Car Leasing
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