Twenty years ago, leasing a car made sense for individuals that were writing-off their monthly payments as a business expense. Today, many people prefer the luxury of driving a new car every two or three years. The shift from buying to leasing cars has led to a large and growing marketplace.
In this article, we are going to discuss what goes into the calculation of car lease payments. That discussion will include some of the more common terms and conditions typically found in a contract, as well as links to downloadable and online tools that can aid in the decision making process.
We have discussed at length a process that can be used to help choose a car that suits someone's needs in our article Buying a Car. Once that process has been completed, there is one last decision: Lease or buy?
The popularity of car leasing has risen dramatically in recent years. There is a constant flow of commercials on television, and on the radio, talking about their inexpensive monthly payments. While automobile dealerships might be celebrating the success of this newfound market, as a consumer, it's important to make an informed decision.
To understand how a dealership might calculate monthly payments, the car must be viewed as an asset. Like many other assets, a car's value goes down over time as the serviceable life of the vehicle is consumed. In other words, the car is subject to depreciation in value over time.
Everyone understands that a car with 100,000 miles on the engine is worth less than it was when first purchased. The market value of the vehicle has gone down. The wear and tear that a car undergoes as it is driven simply lowers its worth. Unfortunately, the total number of miles a vehicle can be driven is considered finite, or limited.
When a dealership structures a car lease, they are using historical data to project its market value at the end of the agreement. 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 dealership has a very good idea what a car of a given make and model is worth when it is three years old and has been driven nearly 36,000 miles. For a vehicle in that condition, let's assume the market value is roughly $10,000.
In this example, the capitalized cost of the car is $25,000 and its residual value is $10,000. This means the monthly payments need to cover the $15,000 decline in value of the car over the lease's term, plus interest expense and fees.
One way that companies are able to provide lessees with low monthly payments is through a mechanism that is referred to as capitalized cost reduction. Essentially, this is an upfront payment that "prepays" some decline in the car's value. It's very similar to the concept of what happens with a down payment on a car loan.
Going back to this example, let's assume the agreement requires a capitalized cost reduction payment of $5,000. This means a $5,000 payment is required at the beginning of the lease. It also means that the monthly payments only have to cover the $15,000 decline in the car's value, minus the $5,000 paid up front, which is equal to $10,000.
The terms and conditions found in a lease typically include upfront fees and security deposits. The money borrowed is also subject to an interest expense, which is known as the money factor. In fact, the effective interest rate charged on a lease can be found by multiplying the money factor by 24.
Nearly all leases limit the number of miles that an automobile can be driven without incurring an excess mileage charge. The range of allowed mileage will usually vary between 5,000 and 15,000 miles per year. Excess mileage charges can add significantly to the cost of leasing a car.
The above example assumed the car would have 36,000 miles on it when returned to the dealership. 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 the dealership sets an annual limit.
If the vehicle has more than the mileage limit when returned, the lessee will have to pay a mileage charge to compensate the dealership for the car's lower value. These charges typically run from $0.12 to $0.25 per mile.
One final consideration before entering into any agreement is the amount of car insurance to carry on a leased vehicle. If the car is somehow damaged to the point where the insurance company considers it totaled, then a gap may exist between the insurance company's payment and the value of the car.
For example, let's say the value of the leased car, as determined by the insurance company, is $8,000. Let's also assume the value remaining on the lease is $10,000. When this disparity occurs, the lessee is responsible for paying the remaining $2,000 on the lease, the gap in the two values, if the car, truck, or SUV were totaled in an accident.
Many new vehicles come with gap insurance, which covers the difference between the value placed on the car by the insurance company and that of the lease. When working with a dealer, it's important to know if the agreement has this feature.
Anyone that would like to see these factors at work should read through our article: Car Lease Spreadsheet. That article contains a detailed explanation of how a monthly car lease is calculated, along with a spreadsheet that can be downloaded for free.
Individuals searching for online tools they can use to run through some scenarios should look at our Auto Loan Calculator section. This contains a wide variety of tools including an online car lease calculator.
The list below contains a number of guidelines that can help keep the cost of a lease to a minimum, or provide help when evaluating offers:
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