You may be among those who have found themselves driving a lot less in the past year while working from home, learning virtually, traveling (a lot) less, etc. Maybe you've been thinking about becoming a one car household or maybe leasing a car. This blog post details what goes into a car lease so you can see if leasing makes sense for you!
What is a car lease?
While most may view a car lease simply as a way to pay for a car, a car lease is actually the financing of a car’s depreciation. Unless you took an accounting course back in high school or college, you may not be familiar with depreciation. Depreciation is “the monetary value of an asset [that] decreases over time due to use, wear and tear or obsolescence”1.
To understand depreciation a bit more, there are 2 key terms: Capitalization Cost (Cap Cost) and Residual Value.
Cap Cost is the gross amount that you are financing. Your goal is to negotiate with the car dealer a low Cap Cost.A lower cap cost means your monthly payment will be lower. Residual Value is the amount the car is worth at the end of the lease. It is typically represented as a percentage which is set by the car dealership based on their best estimates. The Residual Value is typically non-negotiable, but it is still important to understand. One thing to note is that increasing the number of miles in your lease term will lower the Residual Value of the car. This indicates you are putting more miles on the car and therefore the car will be worth less when it is sold.
Depreciation is the difference between the Cap Cost and the Residual Value divided by the amount of months in the lease term.
[Depreciation = (Cap Cost – Residual Value)/# of months]
How is a lease payment calculated?
The lease payment can be calculated through a simple formula of Depreciation plus Finance Charge.
[Lease Payment = Depreciation + Finance Charge]
Now, let’s take a look at the second part of the equation, Finance Charge.
The Finance Charge is the sum of the Cap Cost plus Residual Value multiplied by the Money Factor.
[Finance Charge = (Cap Cost + Residual Value) * Money Factor].
Money Factor (aka interest rate,) is represented by a very low decimal point such as 0.00015 (or another number depending on interest rates). Note, the more zeros, the better it is for you and your payments. The Money Factor is the current interest rate divided by 2400.
[Money factor = interest rate / 2400]
Here’s an example: If the interest rate is 4%, then .04 divided by 2400 equals 0.00167. This is the Money Factor. The Money Factor is typically set by the banks and is non-negotiable. However, Money Factor will change depending on the year, the make and model, and the month you are leasing the car. This is one method car dealerships utilize to help incentivize people to lease older model cars.
*TIP* If you add a down payment to the car lease, it means that you are just lowering the Cap Cost upfront. For a down payment to make sense, the interest rate must be higher than the opportunity cost of investing the money elsewhere. Main takeaway: it really only makes sense to add a down payment if your interest rate is really high.
Here is the breakdown for calculating a lease payment:
Lease Payment = Depreciation + Finance Charges
or
Lease Payment = ((Cap Cost – Residual Value) / # of months) + ((Cap Cost + Residual Value) * Money Factor)
Real World Example:
- 2020 Honda Civic
- Cap Cost = $20,000
- Residual Value = 60 % or .60
- Month of lease = 36
- Money Factor = 4% interest rate / 2400 = 0.00167
Depreciation = ((Cap Cost – Residual Value) /# of months)
= ((20,000-(20,000*0.60)) / 36)
= ((20,000-12,000)) / 36
= (8,000) / 36
= roughly $222.22 = Depreciation
Finance Charges = ((Cap Cost + Residual Value) * Money Factor)
= ((20,000 + 12,000) * 0.00167
= (32,000) * 0.00167
= $53.44 = Finance Charges
Lease Payment = Depreciation + Finance Charges
= $222.22 + $53.44
= $275.66 = Lease Payment
Conclusion
Hopefully, this explanation helps you understand how leasing works and how lease payments are calculated. Note that all leases come in different shapes and sizes. This article is just a basis for you to understand what you are looking at the next time you want to lease a car and how you can budget accordingly. For further information, schedule a virtual meeting with a member of our team by clicking HERE.
Stay well,
Alex