Understanding Car Leasing Terms
Getting a good deal on a car lease is considerably more complex than on a straight purchase. When purchasing a vehicle, you shouldn’t discuss financing until you have settled on a purchase price, and you should shop around for finance sources other than your dealer. For leases, however, you can’t separate the financing (lease contract) from the purchase of the car. You usually can’t find a good price at one dealer, and then get a bank or credit union to buy the vehicle and lease it to you. As a result, you have to find a dealer that both charges a low price for the vehicle and also offers a good deal on lease financing.
Dealers love this complexity. If you don’t understand the entire transaction—or find it difficult to keep track of the financing and price details—the dealer can throw in costs without your even knowing it. But if you want to lease, you still can—and should—get competitive bids. In addition to getting bids on the price of the car, to get a good deal you have to find out about pricing and terms for several lease features.
The first decisions are the length of the lease and how many miles you expect to drive the car during that time. Once you’ve decided on those issues, go ahead and collect additional information from dealers.
As with new-car purchases, get an email confirming commitments on all the details from the lowest bidders.
Because the price of the leased vehicle (“agreed upon value” in the lingo of leasing) is a key element in the cost of the lease, collect all of the information you would need for a straight purchase.
Shop for price first and then for lease features—although sometimes the prices for leases and purchases are different.
In addition to the price, you’ll have to nail down several other details, many of them set by the financing company. As with new-car loans, different financing providers offer different rates and terms. When we get quotes from dealers for our LeaseWise customers, we check our database of lease programs offered by more than 30 sources to identify the programs best suited (best combination of money factor, residual, etc.) to satisfy each customer’s preference. You can also ask dealers to tell you which of their programs will work best for you. Many dealers will identify their best programs without much prodding.
The “lease term” or “duration” is the amount of time you have contracted to lease the vehicle (24 months, 36 months, etc.).
“Capitalized cost” (or “cap cost”) should be separated into “gross” cap cost and “adjusted” cap cost. Gross cap cost includes the agreed-upon price of the vehicle plus any fees, extended service plans, gap insurance premiums, and other add-ons you must pay upfront. Adjusted cap cost—the gross cap cost less any reductions resulting from a trade-in, cash down payment, or rebate—is the amount actually financed with the lease. Many lease ads and some dealerships imply that cap cost is the same as MSRP, but this is untrue. Leasing a vehicle with a cap cost the same as MSRP is like buying a vehicle for full sticker price, which is much more than most customers should pay.
Capitalized Cost Reduction
“Capitalized cost reduction” is lease-speak for a down payment. Your combination of any cash down payment, trade in, and rebate you assign to the dealer reduces the capitalized cost. The bigger your capitalized cost reduction (the more you put down), the lower the adjusted cap cost—amount financed—and the lower your monthly payment.
“Residual value,” the value the leasing company theoretically estimates that the vehicle will have at the end of the lease term, is usually figured as a percentage of MSRP. For example, a $20,000 MSRP vehicle with a residual percentage of 60 percent on a two-year lease is estimated to be worth $12,000 ($20,000 x 60 percent = $12,000) at the end of those two years.
The difference between residual value and adjusted capitalized cost is the amount of principal you will have to pay off during the lease term (you will also have to pay a finance charge, or interest, on the amount of money the leasing company has tied up in the car). Therefore, the higher the residual value—all else being equal—the lower your payments.
Residual percentages and residual values vary with lease term and miles driven per year. Some makes and models of vehicles retain their resale value better than others, and therefore have higher residual values. In addition, manufacturers sometimes agree to buy back cars at lease-end for more than the car is likely to be worth on the market. By subsidizing the residual value this way, car manufacturers keep lease payments lower than they otherwise would be in hopes of leasing more cars. Although a vehicle’s residual value sometimes bears little relation to its real expected future market value, residual value nonetheless is very important because it is used to calculate monthly payments.
End of Lease Purchase Price and Option to Purchase
Lease contracts generally give customers the option to purchase the vehicle at the end of the lease for the residual value, plus a purchase option fee many plans impose.
Sometimes the option to purchase price is not the stated residual value but rather “market value” plus the purchase option fee. Market value may be computed by using one or more market guides.
A leasing company may use either a “money factor” or “annual percentage rate” (APR) of interest to express the way it calculates the finance charge. To calculate the APR for a given money factor, multiply the money factor by 2,400.
Money factors vary for different models of vehicles and lease terms, and different leasing companies usually use various money factors. All else being equal, a lower money factor means lower payments.
When manufacturers want to push leases or sales of particular models, they often subsidize the money factor or APR—offering finance charges lower than general market interest rates.
Many leasing companies charge an “assignment fee,” essentially a processing fee, to set up a lease. The amount varies, but $300 or $400 is common. Some dealers inflate assignment fees and retain the portion they don’t have to turn over to the leasing company. Some leasing companies hide the assignment fee in the monthly lease finance charge calculation rather than expressing it as a separate fee.
“Allowable miles,” the number of miles the lease allows you to drive for no additional charge, typically range from 12,000 to 15,000 miles per year.
“Additional contracted miles” are miles above the allowable miles you contract for in advance at the time the lease is executed for an extra charge, usually expressed in cents per mile.
“Excess uncontracted miles” are miles you drive above the allowable miles and above “additional contracted miles” in the lease. The penalty for excess uncontracted miles at the end of the lease, usually expressed in a cents-per-mile charge, can be quite costly. Try to estimate accurately in advance the number of miles per year you will drive the vehicle.
Early Termination Penalty
Most leases impose a substantial “early termination penalty” for terminating a lease before it expires. It may cost several thousand dollars, depending on when the lease is terminated—the earlier it’s ended, the higher the early termination penalty. Make sure your lease term is correct for you. If there is a significant chance you won’t be able to make payments throughout the lease term, a lease is probably not a good option.
“Gap insurance” protects you if your leased vehicle is stolen or totaled in an accident. From the leasing companies’ point of view, total loss of the vehicle is a form of early lease termination. Typically, your auto insurance company would pay off the claim, but what happens if the car’s market value is less than the amount you owe the leasing company? This difference is called the “gap,” and you would be responsible for paying it to the leasing company. Some leases provide a “gap waiver” that protects you against such shortfalls if you meet certain insurance requirements, but others do not. Gap insurance covers your liability in leases with no gap waiver. It makes sense to buy gap insurance from the leasing company when you agree to the rest of the lease.
Option Discount Adjustment
Car manufacturers sometimes offer special discounts on an option package, and leasing companies often treat these discounts in special ways when calculating residual value.
For example, the invoice for a vehicle model might show an MSRP of $1,000 for a “power package” and a $600 discount for the package—a net price of $400. The MSRP for vehicles with the power package is $400 higher than vehicles without it. But when this model is leased, the MSRP used to calculate residual value (residual value equals MSRP times residual percentage) will include the undiscounted price of the power package ($1,000) rather than its $400 discounted price. In other words, the $600 package discount is added to the MSRP before residual value is calculated.
This peculiar piece of bookkeeping is good for you because it means your residual value will be higher—and payments lower—than they otherwise would be.
Other Lease Language
Auto leases include a number of other features and requirements, among them—
- A security deposit, typically one month’s lease payment rounded up to the nearest $25, is usually due upon execution of a lease. You will get the security deposit back at the end of the lease, unless it is applied to settling excess charges you have incurred.
- With a lease, unlike a loan, the first month’s payment is due upfront. Your first month’s payment is part of the upfront amount you pay the dealer at the start of the lease.
- Lease plans have stringent “excess wear and tear” provisions, and leasing companies will charge you if they determine that you have exceeded normal wear and tear. Some leasing companies are more demanding than others.
- If you do not choose to purchase the vehicle at the end of your lease, some leases charge an administrative fee, usually referred to as a “disposition fee.”
- Leased vehicles usually have stringent insurance coverage requirements. You may have to buy more insurance than you would buy on a vehicle you purchased.