New car leasing 101: A plain English explanation

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Author’s Note: Leasing accounts for a hefty 25% of new-car transactions today, mainly because the monthly payments are much lower than they’d be for a purchase. But most folks don’t end up knowing if their lease deals are good or bad, and they typically can’t explain what they’re paying for or how their payments were calculated. Many find the process confusing, even intimidating, because the lease language has its own oddball jargon, like capitalized cost, residual value and money factor.

If you can’t understand what they’re saying to you, you can’t understand what they’re doing to you.

Finding no clear, thorough description of the ins and outs of leasing on the Internet, I wrote this to help you translate the boomfog you get from salespeople when you mention that L-word.

First, the legalese about who does what

You, the lessee, agree to make specified monthly payments in return for driving car a specified number of miles over an agreed-upon time period — typically two or three years.

The leasing entity is the lessor — a financial company that buys the car from a dealership and leases it to you. Today the lessor is usually the automaker’s captive finance company. The transaction is handled by the dealership, acting as a middleman between you and the car company.

At lease-end, you return the car to the lessor through a dealership for that brand, and you’re back to square one. It’s not a “trade-in” because it’s not your car.

Buying vs. leasing

The monthly payments will always be lower for leasing than for buying. But leasing can be a great choice, a so-so choice or a terrible choice, depending on your financial situation and how you feel about spending your money.

Leasing makes the most sense for people who answer “yes” to one or more of these questions:

• Do you need to minimize your monthly car payments?

• Do you typically get a new vehicle every three to four years?


• Do you own a business that’ll make those payments? (Your accountant may advise you to lease.)

• Do you drive 15,000 miles a year or less?

• Do you always want to be covered by the initial bumper-to-bumper warranty?

• Do you want an extended “trial period” before committing to buy?

Buying makes the most sense for those who answer “yes” to one of more of these:

• Do you typically keep your cars for 5 years or more?

• Do you want to get the maximum value for every transportation dollar you spend?

• Do you drive significantly more than 15,000 miles a year?

• Can you afford to pay off your car loan in 5 years or less?

Leasing is a good option for many people, but it will never be the most cost-effective way to get around. If you lease forever, you’ll be making car payments forever. And you’ll always be paying for the highest depreciation years. The way to get the most value for every new-vehicle dollar you spend is to buy a reliable car, pay it off, then drive it several more years. Making an expensive repair periodically is usually a lot cheaper than buying two or more new cars over the same period.


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New car leasing 101: A plain English explanation

What you’re paying for

Despite leasing’s bizarre vocabulary, the concept is simple and relatively easy to understand. When you lease, you’re paying for these three main elements:

 (1) The principal and the interest on the depreciation — which is the difference between the price you negotiate (which the leasing company pays to the dealer) and the residual value (what the car will be worth when the lease ends).

 (2) The interest on the residual value — which you’re borrowing and driving around for the lease term.

 (3) The sales tax — which is typically your local retail sales tax rate times the sum of the monthly payments for those first two items.

There are some additional costs too…

You’ll pay a lease “acquisition fee” (sometimes called a “bank fee” or “initiation fee”). This is usually in the range of $600 to $1,000. (It’s highest on luxury cars.) This money goes to the leasing company, not the dealer. It is non-negotiable.

There will also be a “disposition fee” — usually a few hundred dollars — if you don’t buy the vehicle at lease-end. This amount will be listed in your lease agreement. It also goes to the leasing company and is non-negotiable.

These fees are important revenue sources for the automakers’ captive finance companies, which write the lion’s share of retail leases. They have more expenses on leases than on purchases. If you don’t buy the car at lease-end, they must inspect it, fix whatever needs fixing, then send it to an auction to sell it to their dealers. Most off-lease cars end up as “factory-certified” used vehicles, an important revenue source for car stores. (They make a higher gross profit margin on used cars than on new ones.)


If you exceed the lease’s mileage limit, you’ll pay an excess mileage penalty to cover that additional depreciation. This is typically 20 to 30 cents per mile and will be specified in your lease agreement. Most leases are for 10,000, 12,000 or 15,000 miles per year. Higher-mileage leases require higher payments, but you should request more miles if you need them. It’s less expensive to build those miles into the lease initially than to pay a penalty at lease-end.

Worth noting: Many leasing ads featuring low monthly payments have a mileage limit of 10,000 miles per year. (Check the fine print.) If they were figured on more miles, the payments would be higher.

Lessors require minimum auto insurance coverage, which may be higher than you typically carry. In addition, you need “gap insurance” to protect yourself if the car is stolen or totaled in an accident. That will cover the difference between what you’ve paid on the lease and what you will still owe, which will usually be more than your auto policy will cover. Gap insurance is built into the price of some companies’ leases, but is an extra cost item in others. Don’t drive a leased car home without it.

Signing a lease is like signing a mortgage. You’re legally bound to make all those payments. If you terminate the lease early, you will owe the amount that hasn’t been paid.

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What you can and can’t negotiate

The only element you can negotiate is the price at which the dealer sells the car to the leasing company. Dealers don’t care whether they sell the car to you or to the lessor.

The leasing company sets the residual value (its worth at lease-end). They base this on the Automotive Lease Guide’s residual percentage tables, which, depending on the miles driven per year, list projected wholesale values of vehicles after two, three, four, five and six years. (I’ve never had a customer lease for four, five or six years.) Those are realistic estimates of the prices they’ll get at auction from the brand’s dealers. Residuals are always stated as a percentage of a vehicle’s total sticker price (MSRP).

The leasing company also determines the interest rate, or “money factor.” Lessees with the highest credit scores typically get the best rates, just as they do if they’re buying.

All dealers quoting on leases from an automaker’s captive finance company should be singing the same song on both the residual value and the money factor (assuming you have no credit glitches).

How they calculate your monthly payment

It’s 5th grade arithmetic. You don’t need leasing software. Any cheap calculator will suffice.


Let’s assume you want a three-year lease, 15,000 miles a year. To calculate the lease payment, you need the following information, most of which you should be able to get from the dealer:

• The full retail/sticker price (MSRP) of the car.

• The “agreed-upon price” you’ve negotiated.

• The amount of the drive-off check, with each element detailed.

• The “final,” or “net,” or “adjusted” capitalized cost, with details of anything that’s been added to or subtracted from the agreed-upon price of the car to get to the total.

• The residual value, which is always a percentage of the full retail/sticker price (MSRP). (Dealers will quote this as either a percentage or a dollar figure.) It will be the “buy-out price” in your lease document.

• The “money factor” or interest rate the leasing company is using.

Let’s use these assumptions to illustrate how they calculate the monthly payment:

• A 36-month lease. 12,000 miles per year.

• A retail/sticker price of $24,000.

• An “agreed-upon”/negotiated price of $22,000.


• A residual value of $12,000, 50% of the MSRP.

• A money factor of .00125. (Multiply this by 24 to reveal the interest rate. This one is 3.0%.)

• A local sales tax rate of 6.5%.

Assume that our “drive-off” check will cover the first month’s payment, a $400 vehicle registration fee and a $600 lease acquisition fee. (Most of my customers pay for those three items up front.) That leaves the $22,000 negotiated price as the “final/net/adjusted” capitalized cost.

So our monthly payment calculation goes like this:

1. The monthly depreciation charge

$22,000 (the final/net/adjusted capitalized cost) minus $12,000 (the residual value) leaves $10,000 in depreciation. Divided by 36 months, that’s $277.78 per month.

2. The monthly interest charge

To get this number we add the capitalized cost ($22,000) to the residual value ($12,000) and multiply the $34,000 total by .00125 (the money factor), making the monthly interest charge $42.50.

3. So the pre-tax monthly payment is $277.78 + $42.50, a total of $320.28.

4. Adding the 6.5% sales tax of $20.82 makes our total monthly lease payment $341.10.


New car leasing 101: A plain English explanation

Who offers the best leases?

The most cost-effective leases almost always come from the automakers’ captive finance companies (Honda Financial Services, Toyota Financial Services, Ford Motor Credit Company, etc.). That’s because the auto companies can subsidize their leases by using some of the profit they make selling cars to dealers to inflate residual values and/or reduce/’buy down’ interest rates to lower your monthly payments. They don’t send that subsidy money to banks, credit unions or other financial entities, so it’s difficult for third-party lessors to compete with the automakers’ lease terms.

All dealers have access to other leasing sources. They need those alternative sources to be able to lease to customers with credit scores below those required by the captive finance companies.

You’ll find lots of auto leasing companies listed in the Yellow pages and on the Internet. Avoid them. They’re just another mouth to feed — “middlemen” between you and the dealer. Negotiate the best deal you can on your own. Then, if you wish to involve them, tell them the total of the initial “drive-off” check plus all the monthly payments and ask if they can beat it. They seldom will.

What’s in a typical ‘drive off’ check?

As noted above, the drive-off check most people write includes the first month’s payment, the Motor Vehicle Department’s registration fee and the lease acquisition fee. If you don’t include the acquisition fee, it will be added to the agreed-upon price of the vehicle and increase the final or ‘net’ capitalized cost. (In New York and New Jersey, states that require all the lease’s sales tax money up front, some customers add that amount to the drive-off check, while others roll it into the capitalized cost and pay it over the lease term, along with a little interest.)

Anything you pay up front over and above those three items, either in cash or in the value of a trade-in, is what you and I would call a “down payment” and leasing companies call a “capitalized cost reduction.” That additional money pre-pays some depreciation, reducing your monthly payments. (On a three-year lease, each extra $1,000 you pay up front would reduce your pre-tax monthly payment by about $28 to $30, depending on the money factor. Note: Cap cost reductions are taxed at the same rate as monthly payments.

Note also that in many leasing ads featuring low monthly payments, the “fine print” often lists a hefty required initial payment of $2,000 to $3,000 or more, much or most of which is a capitalized cost reduction. (You can often beat the monthly payment featured in those ads by negotiating a lower “agreed-upon” price than the one assumed for the ad. That’s because automakers can’t use a price so low that it would anger their dealers. Sometimes those ads use the full retail/sticker price as the capitalized cost!)

Will they deal on the buyout price?

Some lessees purchase their vehicles when their leases end. They like the car and know it’s been treated well. But the buy-out price is the residual value stated in their lease contract. And most lessors refuse to negotiate a lower price.

In a factory-subsidized lease, the residual may have been inflated substantially, resulting in dramatically lower payments. If yours was, you’ve been spoiled rotten for two or three years, enjoying that benefit. The result, however, is a buy-out price that’s much higher than the vehicle’s market value. If your monthly payment is really low, your residual value is probably really high.  

The captive finance companies will get significantly less than that inflated residual value when they auction off the car to their dealers. So you’d think they’d be willing to negotiate a more reasonable price with you. Usually they won’t. My guess: They’re committed to supporting their dealers’ bottom lines by almost “gifting” them those desirable off-lease cars that they can sell profitably as “Certified Pre-Owned” vehicles. They know that financially strong dealers sell more new cars.



That’s how new-car leasing works today. Once you get past the language barrier, the concept is relatively simple and straightforward. You probably know more about it now than the average car salesperson.

For more money-saving advice on automobiles, see our Cars section.

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