Primer on Leasing

I've gotten a lot of questions as to how leasing works.  Here is sort of a primer on leasing, split into a few parts.  This primer will assume you want to lease and have thought about the trade offs vs buying slightly used, etc.  (There will be another post that covers that scenario as well) 

Leasing a car works like leasing any other asset - you pay for only the depreciation of the car (plus a lease fee, expressed as interest, and taxes).  The advantage is that the bank leasing the car to you owns the car and is guessing at what the car is worth based on average wear and tear and the mileage you've build into the lease.  This is often an inexact science and there are ways to come out ahead.  A lease payment is simply the depreciation between today's date and the residual value set by the financing company, with a certain amount of interest and tax.   (your money factor and local sales tax rate).   Please click 'Read More' on the right, to see the rest of this fairly long post...

What to look for in a lease:  A good rule of thumb for a 3 year/36k mile lease is that 1% of the MSRP per month is a good deal.  

People love low monthly payments.  In order to move vehicles, often times, manufacturers will subsidize leasing, either directly through lease cash or rebates or by buying down the lease rate, or indirectly, by working with a captive lender to increase residual value.  Direct subsidies pay down the principle balance, where increased residual makes the depreciation lower.  Often times, you'll find advertisements for loss leader leases, where there is one stripped out base model in stock for a low lease payment that they hope to upsell you to a better car on.  

That said, there are often deals to be had on leases.  If  you've made the decision that buying a new car is what you want, leasing can be a great way to do so.  Or if you aren't sure you want to keep this car for a long period of time, leasing gives you a defined way to get out of it at a particular juncture, as long as you keep the car in reasonably good shape. Here are the typical cases where leasing makes a lot of sense:

1. You know you want a new car within the span of the lease.  This could be an upcoming model or upcoming life change but you know you want a new car soon and don't want to pay all of the sales tax.  In California, sales tax is computed only on the part of the car you use - you get taxed on any Cap reduction at the beginning of the lease, and taxed on the payments you make.  Compare that portion of the tax with a typical acquisition fee, and you almost always come out ahead leasing over buying if you were to sell the car at or before the lease is up.  This requires both reasonable residuals and relatively low money factors to make sense. 
2. You might keep the car but want a defined out anyway and want to live with the car awhile before committing for the long haul.  This is similar to the first one but in this case, you have to have a reasonable residual for it to make sense - this often makes more sense with cars that are heavily subsidized with manufacturer rebates, etc. 
3. Late in the first or second model year, where there isn't enough data about reliability yet, leasing gives people a defined out in case there are problem endemic enough to make values low.   This is a rarer case these days as most cars do fairly well within the warranty period. 

There are cases where leasing does NOT make sense.   These are very common and people end up hating their lease and not being able to do much about it.

1. You aren't getting much of a significant discount on the car.
2. You are being charged high interest rates - always do the math on money factor and compare it to current bank rates - I currently see long financing available for cars at 1.75% and it's not a good idea to lease if the lease rate is much more than that, unless there is a heavy discount off MSRP. (Porsche and Mercedes both typically are sold with large discounts off MSRP but high money factors, which is strange but makes the payments work out better than loans for the most part.) 
3. The car is so new that the residuals are set artificially low.  Do the research to determine what typical cars of that class and make are worth at the end of the lease period.  Often the banks end up getting the cars back at the end of the lease and in order to make sure they sell, they make the residual value lower than the car will be worth.   New car dealers often like lease returns because they are relatively low mile cars that are reasonably well taken care of, that they can certify and sell for a premium over other used cars. 

One common mistake people make is trying to put a large amount of money down on a lease to reduce the amount of interest you are paying.  Remember that interest is charged on the entire balance of the lease, which is the total value of the car, not the just the depreciation.  This is why it is comparable to financing the entire amount of the car.  You only reduce the balance slightly by putting money down, so the difference it makes is relatively small.  The biggest danger of this is that if the car gets totaled after an accident, the insurance company will pay off the leaser first.  The danger is that you might not get your down payment back - depending on how much the car is worth at the time of accident and might need to lease something else without getting your huge down payment back.  Putting down a little bit of money won't hurt but I definitely wouldn't put down much. 

Assuming you fall into a category where leasing makes sense, here are some helpful terms when thinking about a lease:

Glossary of terms

• MSRP :   (Manufacturer's suggested retail price) The residual value is based off MSRP + options.  Not all companies residualize all options, which can make some options really expensive.  BMW doesn't for accessories unless they are installed at the factory, prior to getting to the dealer.  Some port installed options can be residualized, but not all.   Destination charge is included in MSRP as are some manufacturer fees, but not all.
• Residual:  Set by the bank providing the lease, it's a value at the end of the lease that varies on term of the lease and mileage.  The more mileage per year, the lower the residual.  15k miles is a normal mileage, residual values usually go up 2% for 12k miles per year and 3% for 10k miles per year.  Porsche and Audi even offer 5k and 7.5k mile leases (for an extra 1% each) 
• Gross Capitalized Cost:  Actual amount you are paying for the car, + licenses, DMV fees, and accessories and warranties/etc.  
  
• Net Capitalized Cost:  Amount you are paying after any capital cost reduction you put down, to reduce the payments. 
• Security Deposit: Usually a multiple of the payment, put down in order to "secure" the car against damages. Returned at the end of the lease, minus whatever wear and tear you put on it.  Many companies allow multiple security deposits to reduce the money factor.
  
• Acquisition fee:  Amount paid to initiate the lease.  Ranges from $500 - $1000 depending on the manufacturer and bank
  
• Depreciation: Difference between the Gross Capitalized Cost and the residual
  
• Money Factor: interest paid on a lease.  Money Factor is expressed differently than interest chiefly to confuse the consumer, most people can't multiply a 5 decimal number by 2400 in their heads so they often don't know what interest rate they are paying.  Money factor is used to compute the monthly finance amount, or Finance Fee which is the (Net Capitalized Cost + Residual value) * Money Factor.  But you can just multiple money factor by 2400 to get the equivalent interest rate.  So, 0.00100 money factor is actually 2.4% interest.  
  
• Finance Fee: Amount charged each money as interest - see above for formula (Net Cap Cost + Residual value) * Money factor = monthly finance fee. 
• Capitalized Cost reduction (often abbreviated cap reduction): Amount you put down at the beginning of a lease to reduce the total monthly payment.  This slightly reduces the total amount of interest paid on the lease, but not enough to outweigh the risk of losing it in the event of the car being totaled or stolen.
• Sales Tax: The sales tax rate where ever you will garage the car.  In California, you only pay sales tax on the Cap reduction and whatever payments you make.  The advantage is that you pay a lot less sales tax (in the example below, with a 61% residual, you only pay 39% of the sales tax you would if you purchased the car outright.) 
• Payment:  (Depreciation / term of the lease) + finance fee + sales tax.  
• Drive off:  Total amount you pay, out of pocket at the time of lease inception, to take the car.  You can make this zero if desired, but normally it is first payment + acq fee + security deposit + DMV fees or some combination thereof. 
  
• Destination charge: Amount the car company charges to deliver the car to the dealership

The above is all you need to know. Typically, money factors are 1-2% higher than interest rates, unless they are subsidized.  

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We'll use a 2011 BMW M3 convertible as an example.

MSRP:  $81375 (including destination charge)
Invoice : $74980 

Gross Capitalized Cost:  (or Gross Cap Cost) $74730 - (invoice + $200 MACO & $400 Training + $350 transportation fee (dealer trade) - $1000 rebate for Drive for USA... a BMW specific program.  (MACO is an advertising fee levied on the dealers regionally, by BMW USA, training is another fee.  MACO is residualized, training is not.) 

Net Capitalized Cost: (or Net Cap Cost) $74730 - since no additional cap reduction was put down, gross and net are the same.  Remember that anything you put down gets taxed in California as well. 

Residual: $49638.75 or 61% of the MSRP
36 months/10k miles per year: 61%
36 months/12k miles per year: 60%
36 months/15k miles per year: 58%
These values legitimately vary monthly - it is often worth it to ask about other financing periods.  Normally each month is about 1% and any less than that is good. 

Money Factor : 0.00060 or 1.44%

Depreciation :  $74730 - $49638.75 = $26091.25  (Simply the Net Cap cost 

Finance fee :  ($74730 + $49638.75) * .00060 = $75.22

Total Monthly Payment : (Total depreciation - $26091.25/36) = $724.76 + (Finance Fee - $75.22) = $799.78 * (local sales tax - 8.25% in this case - 1.0825% = $865.98

Driveoff:   $865.98 + $925 acq fee + $900 reg and DMV fees = $2690

One thing to look out for in leasing is that most of the time, ads for leases will not include taxes or fees, which as you can see above, can add up to a significant amount, either raising the drive off or payment or both.  The fees are legitimate, but it makes it hard to compare ads with what you actually paid.  Often times, the ads will omit:  Acquisition fee, DMV fees, including Vehicle License Fees, processing fees, taxes on cap reduction, etc.   An easy rule of thumb for DMV is count on DMV fees being about 1.2-1.5% of the MSRP of the car. 

This payment is far less than buying the car and financing the whole thing.  Even at 84 months, which is typically the maximum term to finance the car, you're looking at $1120.92 a month, and at the end of the 36 months, you'd still owe $50,846.31 (or about the residual value) since you paid the sales tax on the entire $81375, rather than on the 39% of the car you used during the 3 years you had it.  In this case, leasing makes a lot of sense, because of the extremely low money factor and the high residual value.  That said, more than likely, buying a 2-3 year old M3 convertible would make even more sense if you were going to keep the car a long time.  

I had a Google Spreadsheet that I used to calculate this, but it kept breaking on my phone when I wanted to change values.  Now, I use Leasematic as a convenient calculator to check out leases.  http://leasematic.com/  It can be a little tricky to use, you always want to capitalize all your fees, and to tax your rebates in CA.  Also, in California, you do NOT want to cap Sales tax.   But, it can calculate what a down payment would do to your monthly, and what Multiple Security Deposits will do to your payment.  You can also calculate trade ins, but be very careful with trade ins - remember that if you owe more than your trade is worth and you want to pay off a trade as part of a lease, you will get taxed on it like a cap reduction if you do it as part of the lease.  Always better to take care of a trade separately, if you can.  

Hope this has been a useful lesson!