Car Leasing Explained

Car leasing can be an efficient way to keep you in a new car for less than the cost of buying. Car leasing works best for those drivers who always budget for a monthly car payment, who want to drive a relatively new car and know about how many miles a year they will drive. Here is how car leasing works.

What You Are Paying For

When you lease a car, you are paying the car's owner - the leasing company - for the right to drive their car for a set number of months and a set number of miles per year. The leasing company buys the car and will sell it when the lease is up. The difference between what the car costs and its value at lease end is the depreciation. You are paying for the depreciation of the car, plus certain fees and expenses.

Capitalized Cost

In car leasing, the capitalized cost simply means what you and the leasing company agree the car is worth at the beginning of the lease period. The leasing company will start with a capitalized cost equal to the Manufacturers Suggested Retail Price, or MSRP, but most often you negotiate that cost down.

Dollars will be added to your "cap cost," as it is called, if you still owe on a previous auto lease or if the payment you want to pay does not cover the depreciation on the car for the cap cost to which you've agreed. This cap cost reduction payment is akin to points on a home loan.

Residual Value

A car's residual value is the estimated worth of the car at the end of the lease period. Car leasing firms must estimate this because no one knows what the market will be in two or three years. But it is important you consider this to be a fair number as the difference between the cap cost and the residual value is the depreciation on which your monthly lease payments will be based.

A good rule of thumb is that for a 36-month lease the car's residual value is 50 percent of its initial value.

Lease Factor and APR

Keep in mind that while you are paying for the car's depreciation when leasing, you actually get the full value of the car for the period you use it. The car leasing company considers that it is loaning you the value of the car above the depreciation and will charge you for that. This is called the lease factor.

Look for a number in your lease documents. It will be a decimal. As an example, it might be .00285. To understand how this equates to an Annual Percentage Rate, multiply that number by 2400. The APR that you get from that calculation should be at or below the current interest rate charged on new cars.

Length of the Lease

The final element affecting your lease payment is the length of your lease. The longer the lease period, the lower your payment will be (because depreciation gets less each year). However, keep in mind, if your lease period is longer than the car's warranty, repairs are on you. Typical lease lengths are 24, 36 and 48 months.

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