Are car leases confusing?

We leased a Toyota Highlander this year and found leases a bit trickier than meets the eye. Being in finance this is embarrassing to admit. With the risk of sounding of being obvious let’s have a look.

Think of a lease payment as having 2 components:
  1. Depreciation. For a 36 month lease, you will use ‘consume’ the vehicle
  2. A loan. During the 36 months, you are borrowing the amount of vehicle that has not been depreciated. A bank actually owns the vehicle and you are borrowing the yet “unused” portion of it. This is the portion you pay interest on. Lease lingo calls it a “money factor”. To convert a money factor to APR just multiply by 2400.
So how do you evaluate the cost of a lease?

There are 3 levers (sales price, residual and money factor) the salesperson can play with and the interaction of the levers is what makes shopping leases complicated. The “residual value” is the buy-out price of the lease at the end of the term, and is represented as a percentage of the purchase price.

Let’s pretend you are looking at a $50,000 car for a 36-month lease. Let’s say the residual is $30,000 or 60% and the money factor is .00001 (ie 2.4% APR). Your lease payment has a depreciation component of $20,000, the amount of car you will consume, divided over 36 months plus a financing charge of 2.4% divided by 12 months times the amount of car remaining. These numbers average out to $555 for the depreciation and $80 for the financing charge for a total payment of $635 per month.

It’s typical to want a higher residual which translates into less depreciation but here’s the catch — the higher the residual, the more car you are “borrowing”. So a high residual AND a high money factor will lead to smaller depreciation expenses but HIGHER financing charges making the lease more expensive than a lower residual lease.

You may find that if you buy the car outright you get quoted a different price. It may be the case that you could buy the car and sell it after 3 years, effectively creating your own lease, with more favorable economics but remember that the lease is an option to buy or as I prefer to call it — an option to sell (it back to the dealer). For the finance inclined, it’s actually a put struck at the residual value. If the car is worth more in the secondary market in 3 years than the residual, you will buy the car at the residual and flip it. If not, you will simply ‘put’ it back to the dealer.

Here’s my spreadsheet allowing you to compare leasing, buying, and what we like to do — a one pay lease, where you make all the payments up front in exchange for a lower money factor. I put a field for “savings account rate” in it to be complete about your opportunity costs when borrowing less money. The calculator assumes no money down and no taxes. Taxes are state specific, and if you do put money down then whether it improves or detracts from the economics depends on whether your loan amount is at a higher or lower rate than your savings account.

This table shows the interaction between money factor and residual. For a given APR you always want a higher residual. It gets tricker when comparing across both axes.

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