Car Buying University

1. Depreciation

If you consider two different cars, both costing $25,000 when new, where one is worth $18,000 after two years and the other worth only $15,000, the first car will cost less to lease because of its smaller depreciation amount.

Different makes and models of vehicles can have dramatically different depreciation rates. Those 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, as has Mercedes, Lexus, and other luxury brands.

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 leasing works.

2. 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.

3. Capitalized Cost

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.

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 capitalized cost possible — a discount off the sticker price — just as if you were buying. The lower your cap cost, the lower your monthly lease payments will be.

Capitalized cost may also include certain fees, such as an acquisition fee (or loan origination fee). Acquisition fees are Bank Fees and they vary depending on a leasing company.

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).

4. 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. But as we explained in Understanding Lease, try to put 0 down so dealer can pay all the fees and first monthly payment for you.

When you subtract cap cost reductions from cap cost, you get net capitalized cost, sometimes called adjusted cap cost.

5. Residual Value

The wholesale worth of a car at the end of its lease term, after it has depreciated, is called its residual 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 subscribe to services that provide this kind of industry data, and then use it 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 deals.

Residuals are usually stated as a percentage of MSRP. A 36-month, 50% residual on a new $20,000 car means that its estimated depreciated value at the end of a 3 year lease will be $10,000. The actual value at the end of 36 months might be higher or lower.
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 60%, decreasing to 52% for 36 months, then to 42% for 48 months, and 35% for 60 months.

Residuals fall rapidly in the first 24 months, then more slowly in later months. This is why shorter term leases are more expensive than longer leases.

The best cars to lease are those whose 36-month 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 to make leasing more attractive. Generally, residuals set by car manufacturers' finance companies (Ford Motor Credit, GMAC, American Honda, and others) are higher than industry averages to help promote lower lease payments.

6. Money Factor

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 .00289. (Note: dealers will sometimes confuse you by quoting money factor as a larger decimal, such as 2.89, which means .00289, because it sounds like an attractively low annual interest rate.)

Money factors 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 .00289 multiplied by 2400 = 6.94%.

A good rule of thumb: Lease money factors, converted to APR, should be comparable to, if not lower than local 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 .00059 (1.42% APR), or lower.

Note that money factor and interest rate is not required to be shown in lease contracts. So, if you want to know your lease rate, you'll have to ask.

7. Lease Term

Lease term is the length of time a car is leased, usually expressed in number of months. Typical leases are 24, 36, or 48 months, although terms, such as 30, 39, and 42 months are frequently seen in lease promotional ads. 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, 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 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 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 makes that have unusually long warranties (Hyundai: 5 years).

You get more for your dollar if you lease for not more than 36 month. It is better to buy out-right if you want to have longer term.

8. Security Deposit

A refundable security deposit may be part of your payment. At lease termination, whether early or as scheduled, Lessor will deduct from the security deposit any amounts you own under Lease and do not pay. Security deposit might be in the range from $300 to $500. Usually is waived with money factor increase by .0001.