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Fundamentals of Automobile Leases

Last updated 29th Nov 2022

Choosing to own or lease an automobile is as much about a lifestyle preference as it is a financial decision. When making a large investment, as is the case when buying a car, it's important to weigh the pros and cons of buying versus leasing the vehicle.

Leasing a car is a popular choice in America today. Many people like the idea of driving around in a new automobile. Leasing is also a good option for individuals just starting out in the working world, since committing to a large down payment on a purchase may be financially undesirable.

Leasing an Automobile

In this series of articles, we're going to cover the more important points to consider when deciding if leasing a car is the right choice. Later on, we will take a closer look at some of the finer points of leasing versus buying a car. But let's get started with one of the easier concepts: the basics of how car lease payments are calculated.

Leasing versus Owning a Car

While a lease allows the lessee to use the car, they never own it. The car must be returned to the lessor at the end of the lease's term. A car loan finances the car's purchase, and the buyer takes full ownership of the automobile only after they've completed their financing obligation to the lender. That is to say, once all of the monthly car loan payments have been made, the car is owned outright.

capital cost reduction
When someone buys a car, they will typically have to pay upfront costs such as a down payment, sales tax, and registration fees. In a lease, a security deposit is paid up-front, as well as the first month's payment, capitalized cost reduction, sales tax, and registration fees. The lessor needs to be sure that when the vehicle is returned, the excessive wear and tear, or small damages, can be paid for and repaired. This is the reason a security deposit is taken.

Automobile Lease Calculations

The payment of a capitalized cost reduction under a lease is similar in concept to a down payment when purchasing a car. Without this up-front deposit, the monthly lease payments would be much higher. Here is a quick example of how that works:

Car Lease Payment Example

Let's say Bill is looking to lease a car for 36 months, at a cost of $25,000, and the interest rates on car loans are 7.0%. Let's also assume the residual value of the car after 36 months is $13,250. In this example, the lease payments will be equal to the car's depreciation of $11,750 ($25,000 - $13,250), plus loan interest on $25,000 at 7.0% for 36 months. This works out to around $438 per month. However, the lease looks much more attractive if there is a capitalized cost reduction of $4,000. In this example, the monthly payments are now only $315 per month.

When the leasing company calculates the residual value of the car, they make an assumption as to the total mileage the car will be driven over the term of the lease. Sticking with the example above, if the residual value is $13,250, the assumption would be the three year old car would have around 36,000 miles at lease end (12,000 miles per year for three years).

If Bill drives the car more than the allowed miles, he will have to pay for the decrease in the car's residual value. If a three year old car with 36,000 miles is worth $13,250, then a three year old car with 50,000 miles is worth less than $13,250; and Bill would have to pay the difference. This charge is referred to as the excess mileage fee, and the annual mileage limit is sometimes referred to as the mileage cap.

Anyone interested in seeing how these car lease calculations are performed can download and use the car lease spreadsheet we've created for free. Later on in this article, we'll explain how to find online calculators that can also be used to run through leasing scenarios too.

Calculation Checklist

Below is a checklist of questions to ask whenever leasing an automobile. If the answers to these questions are known, it's possible to determine exactly how much the car lease costs:

  • What is the agreed-upon value of the vehicle?
  • How much are the upfront payments, including the capitalized cost reduction?
  • Are there any fees paid at the start of the lease?
  • Does the lease require a security deposit?
  • What is the length of the lease?
  • What are the proposed monthly lease payments?
  • Are there any fees at the end of the lease?
  • What are the charges for excess miles?
  • Is there a purchase option at the end of the lease?
  • * Does the lease include gap insurance coverage?

Lease Duration or Term

The lease jargon and terminology can be confusing. The last thing anyone wants to do is enter into a lease agreement and not completely understand the financial commitment they're making on the car.

We have an entire article dedicated to this topic; one that contains over 30 of the most common terms encountered when evaluating a car lease. That information can be found in our car lease glossary.

Online Car Lease Calculators

We stated earlier that we'd help everyone to find online tools they could use to run through some car lease calculations. Those tools appear in the online auto loan calculators section of this website, which contains an online version of a car lease calculator, as well as a tool that can help users to decide if it's better to buy or lease a car.

About the Author - Fundamentals of Automobile Leases

Moneyzine Editor

Moneyzine Editor