If you ask most people that own their cars why don’t they lease a car instead, the most common response will be “because you make all the payments and then you don’t own anything.” In some ways that is true, but mostly not.  At that point of the conversation I go on to explain how a lease works.

In explaining what a lease is we will cover the following terms:

  • MSRP (Manufactures Suggested Retail Price)
  • Residual Value
  • Money Factor
  • Leasing Bank

Throughout we will be using the lease of a new Toyota Camry that has a MSRP of $25,000 as our example.

At the beginning of every month the leasing banks release their rates.  These are comprised of two parts; residual values and interest rates.  Let me explain.  Based on scientific data, location and expected mileage data the bank “guesses” what your car will be worth after the lease is over.  This value is called the residual value.  For example; if they believe your car will be worth 60% at the end of the lease, on the Camry with the MSRP of $25,000, this results in a residual dollar value of $15,000.00.  Simply put the Residual value is the value the bank assumes the car will be worth after the lease is over.  The loss in value is called the deprecation.

Money Factor; this is simply a complicated way to calculate interest, it is the interest rate for the lease.  It ranges from about 0% to 6% on a typical lease.  Worse credit can increase this rate a lot.

Leasing Bank; this is a real bank which is usually owned by the manufacturer directly.  The manufacturers’ use their banks to sell their cars, putting low interest leases to make the payments nice and cheap helps with sales.  There are some other leasing banks as well, such as Chase Automotive finance, US BANK and some local credit unions.  All of them operate the same way, but they differ in credit requirements.  Every bank sets its own credit score tiers. For example, someone with a Fico Auto score of 695 may get the best level approval from one bank, but not on another.  Each bank has its own idea of what kind of customer it likes to approve.  Credit score is most important, but existing debt and income will factor into the decision as well.

Now that we covered all the terms, here’s how it works; We take the bank residual value and subtract that from the sales price after rebates and discounts, we are left with the deprecation amount.  The lease is the total amount of deprecation divided by the term (36 months) plus interest on the full loan, and of course, plus tax.

All three main factors can greatly affect the lease payment.  Even though two cars have the same MSRP, they can vary greatly is lease payment price.

Now let’s compare this to owning a new car.  A car is a depreciating asset, once you drive the new car it automatically drops in value and keeps dropping every month until you sell it.  What a lease does is locks in that loss to set amount and its usually inflated to your favor!  Once you own a car, a small accident or insurance claim will knock of at least 10% off your value.  When you lease a car, the bank just wants a clean car on return, regardless of how much previous damage.  A lease is essentially a finance with an optional balloon payment due after the lease term is up. Yes, you can purchase your leased car if you want, but its only if you want.  All of this plus a lower monthly payment makes leasing the choice for most consumers in the big market areas.  But for many, purchasing and owning is more efficient for their lifestyle, and getting a new car every few years isn’t enticing for them to switch over. Leasing isn’t for everyone, but its growing every year.

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