What to expect when leasing a car: Jargon and math

Are you the type who wants the latest and greatest in automobile technology, and price is a secondary consideration? If so, you may have crunched the numbers, weighed the pros and cons of leasing versus buying a car, and opted to lease.  

Now it’s time to put the pedal to the metal, right? Hold your horse(power) for a moment. Before you sign on that dotted line, you’d better know what you’re signing. You’re about to be handed a stack of forms filled with jargon and math calculations, and you have two choices:

A. Trust that the dealer wouldn’t try to take advantage of your confusion. B. Learn how auto leases work so you can enter the dealership as a confident, empowered consumer.

Please don’t choose “A.”

The auto dealer isn’t necessarily trying to take advantage, but they are trying to protect their interest—the car itself. That’s right. The dealer (or more likely a third-party leasing agent to whom they sell the car) is allowing you to drive and maintain those wheels for a specific time period for a specific price, with specific limitations. 

You typically have the option to buy the car once the lease expires—again, for a specific price—or you can turn it in and start the auto-leasing journey all over again.  

Here’s how it all works, including detailed explanations of each mind-boggling term. There will be no quiz at the end, but passing the final exam means getting a great deal on a lease.

Calculating an auto lease, part 1: The setup

With a lease, you’re really paying for just three things:

• A finance charge to cover the cost of tying up the dealer’s capital over the life of the lease.
• The depreciation on the car over the lease period (whether or not you buy it in the end).
• The total tax on the initial sale, spread over the life of the lease.

To calculate the monthly lease payment, you first arrive at a purchase price, expressed as a “capitalized cost” (aka “cap cost”). This may come from the vehicle manufacturer’s suggested retail price (MSRP), the dealer invoice price, or something in between. Some leasing agents will include taxes in the capitalized cost instead of adding them as a monthly line item. Finally, deduct any down payment and/or trade-in to get your adjusted (or “net”) cap cost.

Because you’re paying for the auto’s depreciation, in addition to knowing the cap cost, you’ll also need to set a residual value. That’s the car’s value at the end of the lease, which may or may not be affected by the car’s mileage allowance and any disposition fees.

Calculating an auto lease, part 2: Breaking down the jargon

There are plenty of terms to know when leasing a car. Let’s take them one at a time:

Adjusted capital cost. This is the amount you’re financing; it depends on how you adjust the cost of the car through down payments and negotiations. A really good credit score helps, too.

Base monthly payment. Consider this as principal and interest, not unlike a mortgage.

Capitalized cost. Think of this as the purchase price; you’ll usually see it referred to as “cap cost.” It’s negotiable, just as when you negotiate to purchase a car. The cap cost includes the price of the vehicle plus the title and license fees.

Capitalized cost reduction. This is a fancy-sounding way of saying “down payment.” It’s the money you put down up front to reduce your monthly costs. It might also include a vehicle you trade in, or factory or dealer rebates and other incentives. (But just like when you’re negotiating and financing a car purchase, incentives and trade-ins can sometimes diminish your additional bargaining power.)  

Depreciation. A car’s value begins to depreciate the minute you drive it off the lot; this is equally true if you’re leasing it. Most cars lose 60% of their value within the first five years, according to Kelley Blue Book.

Disposition fee. This is the cost for wear and tear. The dealer thinks of it as the cost of getting the car ready for resale, and it could blast an unexpected hole in your wallet. Leases are usually pretty specific about how they define wear and tear, so it’s a good idea to know what a scraped bumper or damaged cupholder might cost, not to mention tire treads. If you think something will be assessed as being outside normal wear and tear, consider fixing it before you return the auto, as many dealer service departments will upcharge for end-of-lease repairs.

Invoice price. Pay attention to this one; the invoice price is what the dealer paid the factory for the car, and it’s considered the bottom-line cost below the MSRP. (Remember, the MSRP is what the automaker thinks is a fair price, plus a healthy profit for the dealer.) 

Resources such as Edmunds, Kelley Blue Book, and the National Automobile Dealers Association (NADA) can offer insight into prices. Don’t forget that pricing can vary by region and model availability (something that anyone who tried to buy a car during the pandemic supply chain crunch knows full well). On the flip side, rebates or other incentives could push prices even lower than invoice. In other words, there’s a lot of wiggle room.

Money factor. This may be called the lease factor, lease rate, or even rent charge. It’s really just the interest rate the dealer charges you to borrow against the money it already spent to purchase the car. But it’s calculated by denominations that don’t clearly spell out what the rate is, such as 0.0010, 0.0025, or 0.0033. To convert this to a more understandable interest rate, multiply the money factor by 2,400. So, for example, 0.0025 x 2,400 = 6%.

Why 2,400? It’s algebra based on the average daily balance, which over the life of a loan will be at the halfway (1/2) mark. It’s also a monthly factor, so you divide the annualized rate by 12. And because interest rates are a percentage, you must also divide by 100. And so: 1/2 x 1/12 x 1/100 = 1/2,400.

Mileage allowance. This is another potential danger zone. The dealer needs to set a residual value (see below) up front, and as we all know, a car is worth less with more miles on the odometer. So the dealer will set an annual mileage cap, typically between 10,000 and 15,000 miles per year. Some dealers might offer a higher mileage restriction (for a price). But if you go over what’s allotted, you could find yourself paying anywhere from $0.10 to $0.25 a mile. That can add up fast and furiously.

Purchase option. Most leases allow a purchase option once the lease ends (and sometimes at certain points during the leasehold). The price will be based either on the expected residual value or the fair market value. Most of those terms are agreed on before you sign the lease, which means there’s little if any room for negotiations—but it doesn’t hurt to try. 

Purchasing also leads to other costs, including sales tax, title, and registration fees. (Yes, you technically had to reimburse the dealer for these costs up front, but because a post-lease purchase constitutes a new sale, it will generate a new round of taxes and fees.)

On a brighter note, if you’ve had excessive wear and tear on the car, purchasing means you won’t have to fork over those fees to the dealer.

Whether you decide to purchase depends on everything from the car’s condition to what the market is saying about the vehicle you may have come to know and love. Because the purchase price was set three or four years before—and was really a best-guess estimate—economic conditions may have changed and lifted the value of your car above your cost of acquisition. 

Or perhaps the kids (and adults) in your life stained and scratched that beautiful interior such that it’s cheaper to buy the car than pay the disposition fees. Carefully consider your choices before you drive the car back to the dealership.

Residual value. We know a car’s worth drops (depreciates) once it rolls off the lot, and it continues to lose value as you add mileage, maybe a door ding or two, and just the smallest of tears in the leather seats. This is an estimate of what the value might be when it’s time to give the keys back.

Calculating an auto lease, part 3: Doing the math

Once you understand all the terms, it’s time to put it all together. There are five basic calculations you’ll need to know. Although the dealer will prepare the numbers for you, it’s a good idea to check their math with an online lease calculator. 

For this exercise, suppose you’re considering a two-year (24 month) lease on a vehicle with an MSRP of $26,000, which you’ve negotiated down to $24,500. You’ve agreed to put down $1,500, plus they’re giving you $4,000 for your trade-in. The fees (including tags, title, registration, and lease acquisition) total $1,200. The finance department has agreed to an interest rate of 6%.   

Residual value = (MSRP or capitalized cost) x (residual percentage)

Most dealers use a formula to determine residual value, usually based on current used car rates. Let’s assume the dealer sets a residual percentage as 65% of MSRP.  

Your residual value is $26,000 x 0.65 = $16,900. 

Monthly depreciation = (adjusted capitalized cost – residual value) / lease term

Your adjusted cap cost is your negotiated price minus all reductions, such as a down payment or trade-in, plus the extra fees. 

Your adjusted cap cost is $24,500 – $1,500 – $4,000 + $1,200 = $20,200. 

Subtract the residual value of $16,900 to get your total depreciation of $3,300. Divide by 24 to get a monthly depreciation of $137.50. 

Monthly finance charge = (adjusted capitalized cost + residual value) x (money factor)

The money factor is the interest rate divided by 2,400. In this example, 6% / 2,400 = 0.0025. But why do you add the residual value to the adjusted cap cost to calculate the finance charge? 

Recall that the money factor formula is based on the average loan balance (which is the midpoint between the starting and ending point of the loan). With a lease, you’re essentially paying interest on the average loan balance between the cap cost and the residual value. So, as with calculating any average, you add them together and divide by two (and dividing by two is already built into the money factor formula).  

Your monthly finance charge is ($20,200 + $16,900) x 0.0025 = $92.75. Some auto lease calculators call it a “monthly rent charge” because it’s what you’re paying to “rent” the money used in the lease.

Monthly tax = (monthly depreciation + monthly finance charge) x (tax rate)

Again, some states require that lessors put the taxes in the cost of acquisition, and therefore in the cap cost. Some allow it to be assessed monthly based on your depreciation and finance charges. Let’s assume you pay taxes monthly, and your county’s sales tax rate is 5%. 

Your monthly tax is ($137.50 + $92.75) x 0.05 =$11.51.

Total monthly lease payment = monthly depreciation + finance charge + tax

This is the easy part; the heavy lifting has been done. Add the three costs together to get one total monthly payment: $137.50 + $92.75 + $11.51 = $241.76. You’ll pay this amount to the dealer (or third-party leaseholder) each month for 24 months.  

The bottom line

After 24 months of payments, you’ll either turn in the keys, or else you’ll pay the residual charges plus any applicable fees and call the car your own. But note: If you do decide to take possession, the dealer might offer to finance it for you. That requires an entirely different set of calculations.  

Leasing a car isn’t for everyone. On the good debt/bad debt scale, borrowing money and making payments on a depreciating asset is on the “bad” side. If you make payments and don’t even wind up with an asset at the end, that’s arguably worse. But if you like (and can afford) a bit of luxury—if you know in your heart of hearts that you’ll always want the latest and greatest wheels every few years—leasing might work for you. 

Just make sure you understand the terms and conditions before you sign.