Vehicle Leasing Explained

A shopper’s guide to demystifying standard vehicle leases

©2016 Robert M. Policano v1.0

Most of my career has been in the automotive industry, including experience in the mechanics of lease contracts. I learned that lease deals can be objectively evaluated and compared.

Over the years I have shared my insights with family and friends so that they could feel better informed when shopping for their new vehicles. Lease discussions often intimidate and create anxiety for people when they visit a car dealership. Misunderstanding about how leases work is common, which contributes to shoppers’ worries about getting a “fair” deal, and sometimes leads to negative attitudes about leasing.

I decided to put my knowledge and advice into this guide as a learning tool and resource �for anyone who wants to better understand how lease deals are constructed so they can negotiate their next lease with greater confidence. As the saying goes, “knowledge is power.”

Robert

©2016 Robert M. Policano

[email protected]

robertpolicano

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Preface!

Have you wondered why your lease payments are always more than advertised prices?

Are you confused about how lease payments are calculated?

Do you worry about not getting a “fair” lease deal?

If “yes” is the answer to any of these questions, then this guide was created for you.

©2016 Robert M. Policano 3

Leasing can be a great option compared to buying if you…!

… enjoy having a brand new vehicle every two or three years.

… would rather not drive the same vehicle long enough to reap the advantage of not having �a vehicle payment.

… are comfortable with the idea of always having a monthly vehicle payment.

… do not want to worry about the maintenance and potential repair expenses on an older, �possibly out-of-warranty vehicle.

… do not want the hassle of selling your vehicle when you decide to replace it.

… prefer to “rent” (lease) the vehicle you want for less money per month than it would cost to own [because lease payments are usually lower than they would be to finance the same vehicle].

Following the advice in this guide will help you avoid getting into “unfair” lease deals.!


Every lease agreement is based upon the interplay between three key cost drivers, each of which is very important and significantly effects the monthly payment:


K E Y C O S T D R I V E R S

Understanding how these factors influence a lease is essential to demystify how payments are calculated, determine how “fair” a �lease offering is, and be able to compare one deal to another.

Capita l ized !Cost !

Residual !Value !

Lease !Rate !

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C A P I T A L I Z E D C O S T

Had you decided to pay in full with cash to own your vehicle outright upon delivery, Capitalized Cost is the price you would �be paying. It is the negotiated price of the vehicle.

In a lease, the “Adjusted” (or “Net”) Capitalized Cost is the price after any discounts, rebates, incentives, trade-in credit or add-on costs (e.g., service contracts, current lease balance) have been applied against the MSRP (a.k.a., window sticker or Monroney label price) or negotiated price below suggested retail. That beginning figure before adjustments is listed on the lease agreement as the Gross Capitalized Cost.

The Adjusted Capitalized Cost is the base figure upon which your lease cost will be calculated. !


It is therefore just as important to negotiate the capitalized cost and adjustments when leasing a vehicle as when the intention is to finance or pay in full.

A lower capitalized cost contributes to a lower lease payment 6

Pay attention to the capitalized cost and ensure that it is the best price you can negotiate. !

Ask your dealer if any manufacturer (a.k.a., factory) or dealer incentives are available for the particular model you want. Ask if you qualify for a new or loyal customer discount. If the model is not in short supply or brand new, negotiate a Gross Capitalized Cost below MSRP and as close to Dealer Cost (which you can look-up online) as you can.

If you own a vehicle you want to trade-in to further reduce your capitalized cost, do research online in advance to get an idea what it is worth in the region where you live. A dealer will almost never offer full market value on a trade-in, as they may need to invest money to ready and market it for resale, and will expect to make a profit on it. �If getting top dollar for your current vehicle is a priority, then you should consider selling it privately, and perhaps apply the proceeds towards your new vehicle. Otherwise, be prepared to negotiate the highest trade-in figure for your vehicle, knowing it will very likely be less than full market value.


ADVICE

Trading-in a leased vehicle with time remaining �on it may seem very enticing, but it is not usually a wise financial decision. A lease is a contract and the lessee is required by law to pay all installments and stipulated fees. When a leased vehicle is traded-in early to purchase or lease another vehicle, the dealer will determine the remaining balance owed and add it to the capitalized cost on the new contract. This will �not only make your new monthly payment higher than it would otherwise have been without the trade-in, but means that you will pay new lease charges (i.e., interest) on top of the lease charges already built into your current payment (essentially “double paying”), for the outstanding balance owed on the first lease! �

One scenario when turning in a leased vehicle early does not make bad financial sense is when your current lease company offers to waive the remaining lease payments and end-of-lease fees as part of a “pull-forward” program to get you into a new lease with them. In these cases, all outstanding obligations are voided and will not be rolled into your new lease agreement.

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R E S I D U A L V A L U E

Residual Value is the lease underwriter’s estimate of how much money the vehicle will be worth at the end of the lease. This figure is important because the lessee pays total depreciation, which often represents the biggest part of the monthly payment. !

Residual Value (RV) is a percentage (e.g., 59%) of the vehicle’s original value. On the lease agreement it will appear converted into a dollar amount, so you may need to divide this figure into �the Capitalized Cost to derive the RV percentage.

RVs are future projections based upon many intricate factors that may differ from one lease source to another. Dealers normally have relationships with several leasing companies, each of which could have determined a different RV for the same vehicle.

RVs are linked primarily to time and secondarily to mileage. For example, the RVs for 20-month, 36-month and 48-month leases will be different, usually decreasing significantly every 6-12 months and most during the first two years. !


Standard leases typically allow the average equivalent of 15,000 miles to be driven per year. Usually, up to several RV points will be added for a much lower mileage allowance, or removed for a higher mileage one. If higher mileage is anticipated, it might be cheaper in the final analysis to work the extra cost into the lease payment rather than pay more costly penalties at the end of the lease. It will depend upon how excessive the extra miles are if getting a high-mileage lease or paying the penalty on the backend makes better financial sense.

The RV dollar amount listed on the lease agreement is also the “buyout” price should you want to purchase the vehicle at the end of the lease. Doing this is not common and makes financial sense when the RV figure listed on the lease is significantly lower than actual market value for the vehicle at that time. In this case it might be a good value if you can afford to buy the vehicle outright without a loan, wish to keep driving the vehicle, and/or see an opportunity to sell it privately for a profit.

A higher residual value contributes to a lower lease payment 8

Know the residual value used and ask your dealer if it is among the highest offered from the different lease companies they have access to. !

If you have not already chosen a specific vehicle to lease, research online the cars, trucks and SUVs that consistently rank best in retaining their value over time (i.e., highest residual or resale values). Looking at vehicles that hold their value better than most is good general advice regardless whether you plan to lease or finance. However, a high RV does not assure getting the best lease deal, as the potential of no discounts or higher lease rates on a specific model could counteract this advantage. These conditions will vary vehicle-to-vehicle at any given time.

ADVICE


L E A S E R A T E

Lease Rate, also known as Money Factor, determines the amount of interest charged by the leasing company on the value the vehicle loses (i.e., depreciation) over the lease term. Think of it as the “interest rate” used to calculate the “cost” of the lease.

This is perhaps the most confusing and misunderstood element of a lease contract, and for two good reasons. The first reason is because lease rates/money factors are expressed as a five-digit figure beginning with a decimal point (e.g., .00216), which only automotive finance people who deal with them all the time are familiar with. The second reason is because federal law does not require the lease rate/money factor to be disclosed on lease contracts, only the total dollar amount charged (determined by the lease rate/money factor used), usually labeled “Rent Charge.” Because of this, knowing how the total Rent Charge amount was calculated is not obvious. !


You must therefore ask the dealer for the lease rate/money factor used in your lease or use the figures you have to calculate it yourself (see page 16). Otherwise, it will be difficult to know if you are being charged a relatively low or high interest rate for the lease, and it will make comparing one lease deal to another harder if you are shopping around.

The lease rate used is based upon several criteria, including the lessee’s credit rating (better lease rates for higher credit scores), the term of the lease, and sometimes, also the specific version of a vehicle within a model line.

Lease rates are often described as “standard” or “special,” with special rates temporarily lowered (made cheaper) to stimulate more leases of vehicles the manufacturer and dealer want to sell and rid from inventory. Special rates are rarely offered on new, very popular or scarce models.

A lower lease rate contributes to a lower lease payment 10

Request the lease rate/money factor used and inquire whether or not it is the lowest available from the lease companies your dealer has access to. If high, consider comparable competitive models from other manufacturers that might be offering better deals. !

Unlike financing, in which consumers have many lender options (i.e., banks, credit unions, etc.), most leases are written by the vehicle manufacturer’s “captive finance” company (e.g., Ford Credit). A dealer will usually have alternative lease companies they can use, but generally speaking, they favor the captives. Captives may offer some benefits (e.g., loyalty discount, fee waivers) over other financial institutions, but this is neither universally true nor does it guarantee the best overall lease deal. As a value-conscious consumer, you can and should ask if a better deal could be had from using another lease company, and what the relative pros and cons might be.

ADVICE


While you will probably have a figure in mind for the most you are willing to spend on a lease payment, it is not advisable to divulge your budget until after you have received an initial lease quote from the dealer and know the three key cost drivers. Otherwise, you run a greater risk of ending up with “less” vehicle than you could otherwise have gotten for the same payment—or could have gotten the same vehicle for a lower payment—because you are focused more on the payment number and less on the variables that determine it.!

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ADVICE

Making a down payment on a lease is generally �not advised, as it will increase the “up-front” expense you will have to pay at lease signing. Although doing so will reduce your capitalized cost, which will positively impact your lease cost and monthly payment, it will typically have a minor effect on the overall cost of the lease in the final analysis when you add it to the sum of your monthly payments. This is mostly a matter of personal perspective, but I recommend not putting any money down and getting into a lease with only �the required minimum money due at signing.

This guide does not provide specific negotiation tactics. Some can be found on many reputable websites. If you are not a confident negotiator, seek this information or bring someone who is with you when you are ready to do a deal.

Ask your dealer to compare a couple of different lease terms to see how a shorter or longer lease effects your lease charges and monthly payment. As previously explained, residual values and lease rates are largely tied to the length of the lease term and can vary quite a bit over just a few months, which can sometimes be in the lessee’s favor.


How Dealers Earn Money on Leases!

•  On the capitalized cost amount exceeding the dealer cost.

•  From the mark-ups on any add-ons, such as a service contract, dealer-installed �options and accessories, or insurance product.

•  From any incentives offered by the manufacturer to the dealer not publically known.

•  On a portion of the lease charges shared by the lease company with the dealer.

•  On any extra charges by the dealer, such as “acquisition,” “marketing,” “doc” and “disposition” fees.

•  On the profit from the sale of a vehicle traded-in.


Before You Visit Dealerships !

•  Research online the model(s) you plan to shop, including the optional packages and features available that you may want. Know the MSRPs and dealer costs so that you are prepared to negotiate the lowest Gross Capitalized Cost on the vehicle you choose to lease.

•  Determine how many miles on average the vehicle will be driven each month. If few enough, you could save money with a “low-mileage” lease.

•  Know your credit score. If it is not “top tier,” understand that you may not qualify for the cheapest lease rates offered.

•  Ensure you have sufficient funds to cover the costs that will be collected when you sign your lease agreement. These typically consist of motor vehicle title and registration fees, your first month payment and sometimes a refundable security deposit. Any money you choose to put down will also be collected.


Recap!

•  A lease payment is comprised of three costs: Depreciation, Interest and Tax.

•  The cost of a lease and the monthly payment are two different things. The former refers to the amount of interest paid on the vehicle’s depreciation (i.e., “Rent Charge”). The latter is the installment paid each month, of which interest is one part.

•  Adjustments to the Capitalized Cost, Residual Value or Lease Rate—any one, two or all three—can make a significant difference in the total cost of the lease, as well as the monthly payment.

•  Because of all the variables involved, two lease deals will infrequently be identical, even for very similar vehicles from the same dealership.

•  Advertised lease prices are almost always based upon the base version of the model with no or few options, and do not include state and local taxes or other fees, which can vary by location and dealer. Sometimes they are also calculated with money down. Your actual payment will certainly be higher.


Gross Capitalized Cost $37,000.00 Negotiated Vehicle Price (≤ MSRP)

($2,000.00) Discounts, Incentives, Service Contract, Trade-In, Down Payment and Fees

Buyout Price at End of Lease

Adjusted Capitalized Cost $35,000.00

+/- Adjustments

Lease Term: 36 months Residual Value: 59% Money Factor: .00216

DEPRECIATION COST Adjusted Capitalized Cost – RV (Adjusted Cap Cost × Residual Value %)

Residual Value $20,650.00

LEASE COST (INTEREST) (Adjusted Capitalized Cost + Residual Value) × Money Factor

Total Rent Charge $4,327.34

Monthly (Total ÷ Term) $120.20

Total Depreciation $14,350.00

Monthly (Total ÷ Term) $398.61

TAX COST (Monthly Depreciation Cost + Monthly Lease Cost) × Tax Rate %

Monthly (7%) $36.32

LEASE PAYMENT (Monthly Depreciation Cost + Monthly Lease Cost + Monthly Tax Cost)

$555.13

CAPITALIZED COST (Negotiated Vehicle Price – Reductions + Add-ons)

Study this example to see how the three key cost drivers interact mathe-matically in a lease agreement to determine the monthly payment.!

Actual lease agreements may not disclose the Residual Value % or Lease Rate/Money Factor. Ask the dealer or calculate them using the figures you do have following the methods described below.

Calculating Lease Rate/Money Factor !Divide the sum of the Adjusted Capitalized �Cost and Residual Value into the Monthly Rent Charge (i.e., total divided by lease term in months). Multiply by 2400 for equivalent APR.

Calculating Residual Value Percentage !Divide the Residual Value amount into the Adjusted Capitalized Cost.

Depreciation + Interest + Tax = Payment

MF .00216 × 2400 = 5.18% APR

LEASE COST BREAKDOWN

Total Depreciation Cost: $14,350 Total Lease Cost (Interest): $4,327 Total Tax Cost: $1,308 Grand Total Lease Payments: $19,985

Plus any lease inception or disposition fees, down payment and trade-in amounts


$20,650 ÷ $35,000 = 59% RV

MF = $120.20 ÷ ($35,000 + $20,650) = .00216

In conclusion!

Remember, the reasons you should understand the key cost drivers that determine your lease payment are ultimately to help ensure that you minimize your lease cost and maximize the vehicle �you can get in terms of model, trim level and options for the amount you’ve budgeted.

Why not reduce your monthly payment? Or, at least, increase the portion of it that goes towards �a better vehicle instead of profits to the dealer and lease company?

Now that you understand how leasing works you should be able to ask the right questions and review your lease offers with confidence to get the best deal.

Best of luck!


Automotive

Vehicle Leasing Explained