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What is a Car Lease?

Leasing Questions:

What is a lease? How do I calculate lease payments?

Leasing can be intimidating to understand with its “cap cost this” and “money factor that” semantics. In this article, I will simplify leasing and make you experts so you know how to negotiate deals and speak the language.

*Disclaimer for the number of weary people - You’ll see some math here as we’re still talking about a financial matter. If you know the fundamental concepts of loans and interest, you’ll be just fine.


Let’s start with some definitions:

  • Dealership – The place where all new cars are purchased through. No one can buy/lease cars directly from its manufacturer (unless you have some employee benefit or you’re shopping a Tesla).

  • Bank – AKA the lessor, or financing institution, that you lease from. Most manufacturers have their own financing arm (BMW has BMW Financial, GM has GM Financial). But not all leases go through the manufacturer banks, as other banks can offer lease programs for cars (US Bank, Ally, some bigger credit unions).  Keep in mind, you don’t lease a car from a dealership. Cars are leased through the dealership and you lease it from the bank.

  • MSRP – A car’s “manufacturer’s suggested retail price” is the starting place of all leases. The MSRP is the “full sticker” price. The best way to compare quotes on cars is to FIRST look at a car’s MSRP.

  • Residual Value – In a lease, the bank will estimate how much value a car will retain while you use it. They’ll then place a “residual value” on the car. The residual value will be a percentage based off of its MSRP- not the sale price of the car.

Here’s an example: BMW says an X3 will keep 64% of its value on a 36mo/10k mile per year lease. If you pay full MSRP on the car, you are paying on 36% of the car’s value throughout the course of your lease.

So let’s say an MSRP for an X3 is $50,000. BMW estimates the car will retain 64% of its value so if you pay full MSRP on the car, your lease would be based on 36% (100%-64%) of $50,000.

In addition, at the end of the lease, they will allow you buy the car from them at the pre-determined buyout price of $50,000 x 64% = $32,000. The residual value determines your lease buyout option amount.

  • Money Factor – So the higher the residual, the better the lease right? Kind of. Remember, the bank will charge you interest on the lease. They will set a “money factor,” which will be a tiny decimal number. Multiply that number by 2400 and you get the interest rate on the lease.

Let’s continue that X3 example. As of this date, the X3 has a money factor of .00151. Multiply that by 2400 and you’ll see that the X3 has an interest rate of 3.62%. That’s fairly high.

In contrast, the RAV4, today, has the lowest money factor possible of .00001, or .02%. Essentially this is a 0% interest lease.

  • Cap Cost Reduction – Okay so as long as the MF is low and the residual is high, you can get a good lease deal right? Wrong. There’s a third variable here that’s just as strong as the others called “cap cost reduction.”

In the simplest terms, cap cost reduction is just the discount you get off the sale price, enhanced by incentives and rebates.

Remember the X3 example above? If you pay full MSRP on the car, you’re paying 36% on its MSRP. But let’s say you had a $2,500 discount on the car. $2500 is 5% of $50,000. So if you negotiated your deal and reduced the sale price, you had a “cap cost reduction” of $2500, or 5%, so you’re not paying 36% of the car. You’re paying 31% now.

Divide the 31% across the lease term (typically 36 months), add in your interest, add taxes, add a bank fee, DMV, and any other miscellaneous fees and BOOM: you have your lease payment.

The way that cap cost reductions work are either in the form of a monetary discount off of a car’s MSRP or in the form of rebates that you may qualify for. Manufacturers will run all sorts of rebates to incentivize deals.

How do you find out what rebates are available? As much as resources like Edmunds can help, these resources will not have all of the information. Dealership management are the only ones who really know what the rebates are… and me, because I get the info from them ;-)

  • Which fees are unavoidable? – There are certain fees that are unavoidable in a lease.

Bank Acquisition Fee - The bank will charge you a fee to initiate the lease. This fee typically ranges from $595 to $995 based on the bank.

Disposition Fee – The fee you pay when you return the car after the lease is over. Typically this fee is about $350. You can avoid paying this fee if you lease another car from the same manufacturer as an incentive to stay loyal to its brand.

DMV – Registration costs range on your state’s DMV fees and the weight of your car. Yearly inspections are also dependent on your respective state’s DMV.  

Taxes – We just can’t get around this one. Almost all states will charge you a sales tax. Some states go further by charging you a yearly property tax.

In NYC, you only pay one sales tax but it’s a high rate at 8.875%.

In North Carolina, you pay a low sales tax rate of 3% but you have a yearly property tax rate of 1% of the book value of your car.

  • Over mileage – Your lease contract will state how much the over mileage penalty is. It ranges from $0.15 - $0.25 per mile.

Now that you have some definitions, let’s apply them here:

Here is a simple definition of leasing:

A bank says, “you can borrow this car from us for a certain period of time and mileage allowance, as long as you pay the expected depreciation of the car during your lease, and we’ll charge you some interest on it. At the end of the lease, you can return the car to us or buy it out at the pre-determined price.

Let’s break this down:

A bank says,

“you can borrow this car from us for a certain period of time and mileage allowance.” (Typically 36 months and 12k miles per year.)

as long as you pay the expected depreciation of the car during your lease (MSRP – residual value – cap cost redux)

and we’ll charge you some interest on it. (money factor - multiply this rate by 2400)

At the end of the lease, you can return the car to us or buy it out at the pre-determined price (the residual value of its MSRP).

What makes a lease program good or bad?

Lease programs are the combination of discounts off of a car’s MSRP (cap cost reduction), interest (money factors), and the depreciation of a car (residual value). The combination of these three variables makes a program good or bad.

I like to go by the “1% rule.” If you only pay taxes and fees at signing, and your monthly payment is 1% of its MSRP, that’s a good lease deal. (If the MSRP of a car is $50,000, having a $500/mo payment is good).

If you roll all your taxes and fees in (only paying the 1st month and DMV at signing), and you still have a 1% payment, that’s considered a very good lease deal. Anything less than 1% and that is super fantastic.

Why do some cars lease better than others?

There are the moments where a $25,000 Honda Civic leases the same as a $32,000 Honda Accord. What gives? What’s going on?

Leasing programs are not dependent on which “car” it is. Leasing programs are simply the combination of the three main factors: residual value, money factor, and cap cost reduction. That’s it. It’s all just numbers from here.   

To conclude

Leasing is simply about financing the depreciation of a car during your lease. There are other factors involved, but when we understand leasing in its simplest form, it helps us to discern the value of leasing.

The terms are not as intimidating if you keep practicing the numbers. Enjoy!



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