Philip Hall is a financial professional based out of Raleigh, NC. Having worked for over 15 years on Wall Street he has developed an insider’s view of the financing world, and in this article makes use of that experience to decipher car leasing and help you understand how it really works.
Ever been confused by car lease deals? Not sure why a $50,000 car might lease for less than a $30,000 car? Been tempted by a lease offer but never been able to find that deal on a car you actually want? Hopefully this article will explain car leasing in terms that a normal human being can understand!
For me the auto industry is one of the least transparent, consumer unfriendly industries in existence. That’s coming from someone who spent most of his career working on Wall Street and having a healthy cynicism for that business, so it’s saying something when I think an industry is as bad if not worse than financial services! It truly amazes me that in this day and age cars are sold the way they are. A car may be the second largest purchase you ever make, and indeed if you regularly update your cars it may end up over your lifetime being the largest expense you have. Yet cars are sold at wildly varying prices by an army of sales people who have no idea what they are selling and are just looking to dupe as many of their customers as they possibly can. And while I happen to think car leasing is a fantastic idea conceptually, it is an area that has allowed car dealers and sales people to obfuscate pricing even further.
Note this post is not intended to compare leasing with buying and the relative merits of each. Rather this post is simply intended to provide a comprehensive explanation of how leasing works.
Car Leasing – The Concept
When you lease a car the basic concept is that rather than you buying the car yourself, a finance company buys the car and you lease it from them. The finance company will charge interest on the entire cost you paid for the car. However unlike a normal auto loan where you also repay the entire principal balance that you borrowed in addition to interest, with a lease you only pay “principal” on the amount that the car will depreciate during the term of the lease. Of course nobody knows what any car will be actually worth in 24 or 36 months time, and so when you lease a car the finance company assigns a “residual” value which is generally based on what they think the car will be worth at that time. Residual values are always set as a percentage of the full manufacturers suggested prices (“MSRP”), and will vary from one model to another and from one manufacturer to another. The residual value will also vary based on the allowed mileage for a lease, with the residual amount being lower the higher the allowed mileage.
So the three KEY things that will affect your lease deal are the price you pay for the car, the interest rate you are being charged on the financing, and the residual value of the car.
Lease Factor 1: Price you Pay
The auto industry, being the beast that it is, has some bizarre terminology to generally hide these concepts from you. The price you pay for the car is called the “Capitalized cost” and any discounts are referred to as the “Capitalized cost reduction”. These terms sound pure wall street and I am guessing derive from terms used in the backend securitization of pools of these loans but the key thing you need to focus on in getting a great deal is paying the absolute lowest price possible for the car. It may sound obvious but people tend to focus on the payment not the price of the car and dealers are well aware of this and play to it. Most dealers would be very happy to work out a lease deal without ever even telling you what you are paying for the car. The bottom line price you pay for the car including all incentive discounts is key to making a lease deal attractive.
Really excellent lease deals come up when cars have significant discounts to their MSRP. While of course this is true of traditional car purchases too, the reason it works particularly well for leases is a car that is selling for say 20% of MSRP may result in something like a 50% reduction in the amount of depreciation it takes during the lease term. It is this leveraged effect that makes really great lease deals.
Lease Factor 2: The Interest Rate you Pay – “Money Factor”
Once again this one gets obfuscated by the industry and for some bizarre reason that I cannot explain is quoted as a “money factor”. In order to convert a money factor to a normal interest rate you multiply it by 2,400. So if the money factor is 0.000125 then the interest rate is 0.000125 * 2,400 = 3%. There is literally no explanation for the use of this term other than to confuse buyers and hide true costs from them. Again the bottom line is you want the interest rate to be as low as possible when leasing a car. Lease rates are generally not negotiable, however car dealers have a reputation for upcharging the interest rate or money factor. Essentially the financing company will publish it’s applicable money factor for a given lease and the dealer can make more money by upselling this. To avoid this, do an internet search to find the current money factors for the model you are looking at. The forums on Edmunds.com have some great resources for this.
Tip: Multiple Security Deposits
“Multiple Security Deposits” or “MSDs” are a little known feature of auto leases that can substantially reduce the money factor, i.e. the interest rate you are paying for the deal. They are not the same as the regular “security deposit” which is money you put down upfront which essentially just pre-pays your lease payment. You really should NEVER put any money down as a security deposit, see my note on that below.
When you put down MSDs they are held by the finance company until the end of the lease and then assuming you made all your payments they are returned to you. Thus they are essentially just like additional collateral the finance company takes (in addition to the car itself) and in return they provide cheaper financing. They are a little quirky in that each MSD is calculated as exactly one monthly payment (so the MSD depends itself on the deal you get in a circular fashion) and each one will subtract a certain amount from the interest, usually down to some minimum interest rates when no further MSDs can be applied.
MSDs are not available with all companies, Google is your friend in working out who, but some that I do know offer MSD programs are Infiniti, BMW and Audi. When they are available they are almost always worth using as the savings you make on the lease payment in comparison to the amount of money you tie up are usually very attractive.
Tip: Regular Security Deposit or Downpayment
Most advertised lease deals assume a certain down-payment to make their numbers work. You know the ads – lease our car for $199 a month, $2999 due at signing. My advice here is very, very simple: never, EVER put down any money on a lease, unless it’s an MSD. Literally all you are doing is pre-paying your payments without anything in return. You are better off putting that money in a bank account and using it to “subsidize” your monthly payment yourself. If you ever want to trade out of the lease, or your car is totalled and the insurance pays off the remainder of your lease balance, unlike MSDs any regular downpayment is lost. There is absolutely no circumstance whatsoever that I recommend you put any money down on a lease.
Lease Factor 3: The Residual Value
The final factor that affects a lease deal is the value assigned to the car at the end of the lease. This is critical because the largest part of your payment is likely going to be the difference between what you pay for the car today and this residual value. The residual values should in theory correspond to what the financing company actually thinks the car is going to be worth at the end of the lease, but often times they are adjusted upwards or downwards depending on how desperately a company wants to sell a given model (the finance companies for auto leasing are generally subsidiaries or affiliates of the manufacturers). So the really juicy lease deals exist when a manufacturer artificially inflates the residual value in order to make lease payments more attractive.
Sidenote: at the end of the lease you have the option to purchase the car from the financing company for the residual value. This make sense – say the car cost $30,000, and the residual was $18,000. During the lease term you pay the financing company $12,000 to cover the deprecation, so if you want to keep the whole car you can pay them the remaining $18,000. This is an example of what I would call a positively biased option – if at the end of the term the actual value of the car is less than the residual value then you can simply turn it in and the difference becomes the problem of the lease company. However maybe there is a glut of supply of the particular model you own and it’s actual resale value is higher than the residual value. Well you now have the option to purchase the car and sell it for the higher value and pocket the difference. This is an option where you have all the upside and the other party – the finance company – takes all the downside. I love financial products that exhibit this positive bias.
What About Taxes?
Sales tax can definitely complicate lease deals and unfortunately each state treats it differently. In some states sales tax is applied to the initial car purchase, and then your payment is just based on the factors described above. In other states no sales tax is applied to the initial purchase but is added on to your ultimate payment. In the worst possible states sales tax is applied to BOTH, making leasing far less viable. You should check how sales tax is applied in your state to understand fully the implications of leasing.
In addition if you do exercise that purchase option at the end of the lease then that becomes another sale. During the lease term the car is owned by the finance company, and when you exercise the purchase option then you basically buy the car from that company for the residual value. At this point sales tax can also be applied to that transfer so you pay the residual value plus sales tax to acquire the car.
Bringing it all Together – What Makes a Great Lease Deal
In simple terms a great lease deal exists when you can buy a car at a big discount to its MSRP, with a low interest rate (“money factor”) and a high residual value. If you can get the trifecta of attractive numbers on all three of those that can lead to some exceptionally good valued lease deals.
Let’s take a look at an example of a deal I saw recently and see what makes it a great lease option. In this case it was the Infiniti Q40. This is a great example that shows how all the factors described above come together to make for a hugely compelling lease deal. For this example I am going to use a fully loaded Q40 which to keep the numbers simple has an MSRP of very close to exactly $40,000. This is a real deal not a fictional example that was posted and discussed in depth on Slickdeals in 2015.
This particular deal worked best for a 24 month lease where Infiniti Finance was offering a base money factor of 0.00039 (i.e. an interest rate of 0.936%, less than 1%) and a 24 month residual value of 64% assuming 12,000 miles driven per year. Let’s compare the numbers assuming you pay FULL MSRP to begin with. For comparison purposes I am going to assume that if you bought the car you finance it using a 4 year loan, and I will simply use the same implied interest rate as the lease rate. In both cases for simplicity I will assume you put zero money down and all fees are paid for out of pocket, and I will ignore sales taxes. I will also round all payments to the nearest dollar.
Full MSRP Cost Comparison – $40k price
Loan payment on 4 year loan purchase: $849 per month
Lease payment on 24 month lease: $626 per month
This is how it looks paying full “sticker” price for a $40k car, something a surprisingly large amount of people who lease end up doing. The lease payment is more “affordable” than the loan payment and that’s what makes it attractive, but the difference is not huge and so in many cases this type of “deal” it may be better to just buy outright.
Reduce Price Cost Comparison – $30k price
The main thing that made this particular deal really attractive is the Q40 was being massively discounted. At the time of the deal the Q40 was coming close to the end of it’s life and was noted to be a car slated for replacement with some new model. And so Infiniti and it’s dealer network were heavily discounting the car to clear the remaining stock off of their dealers lots. At the time this car was being sold for as low as $30k, a full 25% discount to MSRP. Let’s rerun the numbers. The key thing here is that the residual is ALWAYS based off of the MSRP not of the actual price the car is sold so for the 24 month deal the residual at 64% was still $25,600. So the depreciation at a $30k selling price is just $4,400 as opposed to $14,400 at full price:
Loan payment on 4 year loan purchase: $637 per month
Lease payment on 24 month lease: $205 per month
Yes that’s right the base lease payment drops to just $205 per month for a car with a $40k sticker!!! Of course the payment for a loan goes down in exact proportion to the discount, it’s a 25% discount to the MSRP loan level. But because of the leveraged effect on the drop in the depreciation, the monthly lease is just 33% of the original payment despite the car price being 75% of the original.
Further Reduction Through MSDs
Infiniti is one of the companies that accept Multiple Security Deposits. Now in this case the interest rate is already low to begin with so the effect of applying MSDs is not as big as the effect of the upfront discount, but it still shows how beneficial MSDs can be. In this example we take 3 security deposits to bring the money factor down to 0.0009, or 0.22%.
Lease payment on 24 month lease $188 per month
So you would “deposit” 3 x $188 = $564 with Infiniti and save yourself $17 a month or $408 over the 24 month lease. So by tying up just $564 for two years you save yourself $408 – pretty hard to find any investment that would come close to that kind of return over a two year period.
Now at the end of the day my example is over-simplified to not include any fees that get added on such as bank fees the finance company charges, and most critically sales tax which will be an issue for most. But the reality is in this case it was possibly to get a car that would at the very least cost you something in the $640 per month range even when heavily discounted for much less than half of that because of the trifecta of low acquisition price vs MSRP, a low interest rate and a strong residual value.
The key to getting an excellent deal on a leased car is simple, you need to find an opportunity where as many of the these three key factors are at play:
- Low purchase price in comparison to the MSRP
- Low interest rate or “money factor” on the lease financing
- High residual as a percentage of the MSRP
Some companies allow you to use Multiple Security Deposits or MSDs to lower the money factor. These are invariably a good deal. However never, ever put down any regular downpayment on a lease, always put zero or as close to zero as you can.
Hopefully you found this post a useful insight into car leasing, if so please share it, like it or +1 it in your social media network!