Car Leasing Defined
The basic concept of leasing is very simple. After driving a vehicle for a certain amount of time and number of miles, the car will be worth less. If you bought a brand new car and then drove it for three years, it would now be worth less than when it was new. For example, a brand new car cost $20,000, but after driving the car for three years, it is now worth only $12,000.
A lease is defined as the bank presetting the value of the vehicle after the customer drives it for a number of years. In the scenario above, the bank may decide that after the customer has driven the new car for three years, it will be worth $12,000. The vehicle’s value at the end of that period of driving is called the Residual. By forecasting a residual value for the vehicle, it is possible to calculate how much per month it will cost the customer to drive the vehicle.
In this scenario, when the customer returns the car to the leasing company, it will be worth $12,000, and because the original cost was $20,000, the customer has only “used” $8,000 of the car’s value. This means that the car has lost $8,000 in value over three years. $8,000 divided by three years (36 months) is $222 per month. Keep in mind that you must also add the bank’s fee (think of it as interest) to each payment. Lease payments are calculated by subtracting the residual from the net selling price, dividing that amount into payments and then adding the lease charge. This calculation can be accomplished on the spot using the formula illustrated below. If you plan to negotiate a lease, we recommend that you know how to calculate a lease on the spot. This will verify the payment amounts and prevent excessive “Back-End” dealer profits. You can also use our Leasing Cheat Sheet and Lease Payment Checker.
How to calculate a lease:
A Lease payment is comprised of two elements: depreciation and lease charge.
• The first element is the depreciation, which is how much value the vehicle will lose every month.
• The second element is the lease charge, which is the fee charged by the leasing company.
Lease Payment = Depreciation + Lease Charge.
First calculate the Depreciation: To calculate the depreciation, you must subtract the residual (how much the vehicle will be worth at the end of the lease) from the selling price. For example, if you buy the car for $20,000 and at the end of the lease the car is worth $12,000, the car has depreciated in value by $8,000 ($20,000 - $12,000 = $8,000). Divide the depreciation ($8,000) by three years (36 months). Therefore, every month the car depreciates by $222 ($8,000/36 months = $222). Depreciation = (Selling Price - Residual)/Number of Months ($20,000 - $12,000)/36 = $222.
Next calculate the Lease Charge: To calculate the lease charge, you will need to know the Money-Factor. The money-factor is the number that is used to calculate the bank’s fee. To make it simple, think of the money-factor as the “interest rate” for the lease. It will be a number that will look something like this: “0.0035.”
First, add the net selling price to the residual. This seems odd at first, because when you add the net selling price to the residual it yields a large number. For example ($20,000 + 12,000 = $32,000). Then multiple that “large” number by the money-factor (0.0035) to get the monthly lease charge ($32,000 x 0.0035= $112).
Now add the depreciation per month ($222) to the Lease charge ($112) and get the monthly lease payment of $334. ($222 + $122 = $334)
Here is the entire lease formula:
((Net Sales Price - Residual)/Term) + ((Net Sales Price + Residual) x Money-Factor) = Monthly Lease Payment.
Convert the Money-Factor to an Interest Rate:
Another helpful formula to use during lease negotiations is the calculation to convert the money-factor to an Interest-Rate. Keep in mind that if this formula produces a high interest rate, it doesn’t necessarily mean that it is a bad lease (See the article on Money-Factors and Residuals). To convert a money-factor to an implied interest rate, multiply the money factor by 2,400 (Money-Factor x 2,400). For example, the money factor is 0.0035. Multiply 0.0035 by 2,400 and the result is 8.4 or 8.4% . Formula: (Money-Factor x 2,400)
Keep in mind that there is a different terminology that can be used when leasing. A lot of these terms are held over from industrial equipment leasing and can be confusing. However, the definitions are quite simple: the two leasing terms you will hear the most are “Cap-Cost,” which means selling price, and “Net¬Cap-Cost,” which indicates the selling price less the down payment and trade-in.