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CAR LEASING WILL likely make a comeback in 2023. But is leasing a good idea?
Before the pandemic, leases represented about 30% of new car sales and as much as 70% or 80% for some luxury vehicles. But during the pandemic, with new vehicles in short supply, manufacturers reduced their generous lease subsidies. This, combined with low interest rates, reduced payment differences between financing and leasing, making leasing less attractive.
But that may be about to change. With the average new car price exceeding $48,000, according to Cox Automotive, and interest rates significantly higher than a year ago, leasing could become a more attractive option.
Why take the time to learn the math of leasing? It’s important to be a knowledgeable consumer. When a dealer quotes you a lease payment, how do you know that the price you negotiated for the car is the price on which the payment is based? Some dealers try to negotiate a lease based on the monthly payment and avoid a conversation about the purchase price.
How does leasing work? For a specific term, which is typically 36 months, consumers make a monthly payment and then, at the end of the lease, they return the vehicle to the dealership. Alternatively, at the end of the lease, they can choose to buy the car based on the contracted residual value.
The math behind a lease is fairly simple. It’s the vehicle’s projected monthly depreciation plus the monthly interest. The depreciation varies by make, model and trim. To make the depreciation calculation scalable based on a car’s price, the financing arm of car manufacturers express a vehicle’s residual value at the end of a lease as a percentage of the MSRP, or manufacturer suggested retail price. It’s frequently in the 50% range for a 36-month term.
Cars with good resale values have higher residual values. That translates to less depreciation and hence lower lease payments. Say a vehicle with a $44,000 MSRP has a 55% residual value. That works out to $24,200. If you subtract the $24,200 residual value from the $44,000 negotiated sales price, which I’m assuming is the same as the MSRP, you get $19,800 in projected depreciation. Divide the projected depreciation by the 36-month lease term, and you get $550 in monthly depreciation.
Next, we need to calculate the monthly interest charge. This starts with the capitalized cost, which is basically the amount being financed. Capitalized cost is the negotiated sale price, plus the lender’s lease acquisition fee and any dealer fees, minus the down payment. For instance, in our example, if it’s a zero-down-payment lease, the capitalized cost would be the $44,000 negotiated price, plus perhaps a $650 lease acquisition fee, plus maybe $400 in dealer fees, for a total of $45,050.
The capitalized cost is added to the residual value, and then multiplied by the money factor. The money factor is the interest rate for a lease. Using our example, you’d add the $45,050 to the $24,200, and then multiply by the 0.0025 money factor. That results in $173.13 in monthly interest. (It might seem like you’re charged interest twice on the car’s residual value—after all, that residual value is also included in the negotiated price—but the money factor adjusts for this perceived double counting.)
If you add the monthly interest payment to the monthly depreciation, you get the lease payment, which in this case would be $550 plus $173.13, or $723.13 total. Want to convert the money factor into an interest rate? You multiply the money factor by 2,400. Thus, a money factor of 0.0025 is equal to a 6% interest rate.
For simplicity, I have left taxes out of the equation. In most states, the sales tax is calculated on the monthly payment and not on the sales price of the vehicle at the time of leasing. This tax deferral is seen as another advantage of leasing.
According to a study done by CNW Marketing, the top three reasons consumers lease are lower monthly payments, smaller down payments and the chance to drive a nicer car for the same monthly payment. Meanwhile, the top complaints about leasing are the penalties at the end of a lease for exceeding mileage allowances and for wear and tear, the fact that you don’t build any equity, and the cost to exit a lease prior to the lease’s scheduled maturity.
Meanwhile, why do car manufacturers like leases? There are three main reasons:
Is leasing a wise move? It depends on your circumstance. If you buy cars and keep them for a decade, leasing is not the right route. But if you plan on getting a new set of wheels every three years, it might be worth considering.
Darwin Beloate spent 35 years in the automotive industry. He started working at an Isuzu dealer in Marietta, Georgia, while in high school and worked for car dealers in parts, service and sales throughout college. In 1990, he graduated from Northwood University with a degree in automotive marketing and worked for Nissan North America in marketing and sales positions for 30 years. He’s been a real estate investor since 2015 and, in his spare time, enjoys track days in his 1994 Mazda Miata R type.
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There is only ONE reason car manufacturers love leases. Over time they extract the most money from the consumer. The TCO of leasing still exceeds the TCO of purchasing a vehicle.
By far the most efficient use of your money is to purchase a prove-reliable 2-3 year old vehicle (yes, even in today’s market), maximize your down payment (or pay cash if you can), then keep that vehicle till it dies.
My wife and I own a 2002 Suburban (245k miles) and a 2012 Acura (155k miles). Both vehicles are well-maintained and running as well as the day we bought them. We have a minimum of 50k miles left on both vehicles, probably more. We haven’t made a car payment in 7 years, we haven’t paid sales tax in 9 years, and our total insurance costs are < $900 annually. I estimate that the amount of money we have been able to put away (rather than spending it on depreciating assets) and the return on those investments over the last 20 years has increased our net worth by close to $300,000.
Most who lease do not not negotiate the purchase price, so they overpay. Buy a quality car (check out quality reports online). I buy Lexus SUV’s and have a 2004, a 2013 and a 2020. Get your oil changed and they last a loooooong time.
Many pros and cons for leasing, but “trouble free” strikes me as the most common thought – you just write the checks for new cars that only you have driven. If purchasing, and you are lucky, there is a sweet spot between loan payoff and that time when repairs become necessary as the depreciation nears the bottom. Those glorious few years when you are only paying for fuel and insurance, etc. can be short-lived, or maybe long enough to save a nice downpayment on your next replacement vehicle that will eventually be needed. I have both owned and leased top of the line vehicles many years after having to tolerate shit vehicles for several years. I only leased when unsure if the target vehicle would suit my needs – if it didn’t then back to the dealer, gone, hassle free, no eBay BS, no low-ball trade offer.
Excellent article, great amount of useful detail.
I always felt that leasing was more expensive but had its place.
I used to use this site called swapalease where my family would assume (for no money down) leases that folks wanted out of.
It was often very profitable, someone had to leave country, situation changed, parent could no longer drive and wanted out of a lease.
Great info! As a veteran of the car finance business, I have a few additional pieces of info.
Dealers love the lease alternative because they can add more profit to the front end of the deal. They also have more after-sale contact since lessees usually return the vehicle to the leasing dealership.
Manufacturers also add subvention to sweeten the deal. Manufacturers like to move metal and speed up the purchasing cycle.
Leasing companies make ~30% return on a lease because they can depreciate the vehicle since they are the owner.
Never put money down on a lease. This is the equivalent of putting money down on an apartment rental. Hang on to your money.
Leasing is renting, nothing more. You are responsible for care, maintenance, insurance, and wear and tear. That last one can be contentious . What is normal wear and tear? If your state has ad velorum taxes, you pay those. You also pay for yearly registration.
Purchase option? This may have a fee. It is also a sale, so there will be sales taxes.
There may be another lease-end fee for simply returning the car.
Good luck.
To lower the depreciation hit, but stay relatively current with safety tech I tend to keep cars about about 6 years, thus have never even considered a lease. I was toying with the idea of going EV with one(range anxiety) of two cars. New EV credits have eliminated federal credits for my single filer income as well as for most of the desired non qualifying cars. However I understand the leasor would sitll qualify for incentives on any EV and may or may not choose to pass on the credits within the lease. If they would, could a lease reap the credits via a short term lease and then purchase the vehicle? Basically, short term financing with a lease to get EV credits and then purchase to lower long term depreciation costs?
Is car leasing a wise move? In my opinion, as someone who has lived debt free for many years absolutely not. My wife and I drive very nice slightly used cars that we paid cash for. For anyone considering leasing a vehicle, I would recommend reading The Millionaire Next Door by Thomas Stanley (https://themillionairenextdoor.com/) and Baby Steps Millionaires by Dave Ramsey (https://www.ramseysolutions.com/store/books/baby-steps-millionaires-by-dave-ramsey). They found that very few millionaires lease new vehicles and usually drive older model vehicles.
Here is another link that explains car leasing (https://www.ramseysolutions.com/debt/how-does-a-car-lease-work).
Ask why do manufacturers and leasing companies lease? Not to be nice to consumers, but to make money! When one bases their decision primarily on the monthly payment they are falling for the rhetoric. “Marketing is the rattling of a stick in the bucket of swill.”
In very few situations is a lease the “best” option financially. I had a client who was a very successful realtor. Her husband (he handled their financial and tax matters and she sold a lot of RE) asked me to analyze whether a purchase of lease was a better option. Due to the type of clients she served, she needed a new luxury car every few years. We determined the criteria for purchase and lease analysis, and my analysis indicated, in her situation, a lease was the better option for tax and cash-flow purposes.
Don’t base a decision on a single criteria.
I appreciate this contribution to Humble Dollar. It’s a financial primer on a black box I’ve had some curiosity about.
A car is for most people their first major financial expenditure. For many it’s their largest in life (not everyone buys a house, or goes to college.).
Important assistance to the general public to improve their financial savvy about cars and their costs. That’s a good thing, given how entangled our egos can be with our means of personal transportation.
Smart people stay off the LEASE TREADMILL. A great way to piss away dollars. Quality foreign cars last a decade at the minimum
My last 2 American cars also lasted 10 years.
Thanks for this article. I always wondered about a lot you have clarified. I have been toying with a lease idea, but not sure.
I admit though if I did lease I probably would focus on the monthly payment and making sure the allowed driving miles was more than adequate.
What is your view on leasing vs buying an EV? I’m thinking at this time, I would only lease to give it a try.
The main knock against car fleecing…aah, sorry, I mean car leasing…is that the vast majority of people only look at the monthly payment and make their entire decision based upon that number. They do not look at the entire cost of vehicle ownership, including the financing costs and the cost to buy and the amount received when sold. If someone is changing vehicles to another new vehicle every three years, the first question they likely should ask themselves is if that is something they can afford to do. I would submit that it is a very small subset of the population that should continually be upgrading to the newest vehicle.