Fighting Chance New Car Buying Guide - Leasing 101

Leasing 101

(The Basics, Demystified

For These Tough Economic Times)

©2009 Fighting Chance® & James Bragg

Have you ever wondered how new-vehicle leasing works? Whether you should buy or lease? What you’re paying for when you lease? What you can and can’t negotiate in a lease? How they calculate your monthly lease payment? How leases are taxed? Whether you get the incentive if you lease? What’s in a typical leasing “drive-off’ check?

If you’ve answered “yes” to any of these questions, this Leasing 101 tutorial has the answers you need. At no charge.

Fighting Chance customers tend to be smart, highly-educated people. But over the years, I’ve talked to thousands of them who didn’t understand leasing. Many were in previous leases, but had no idea whether their deals had been good or bad. Most couldn’t explain what they were paying for or how their payments were calculated. They only knew that their monthly payments were lower than they’d be if they were buying.

I’ve also talked to many others who were on the fence between buying and leasing, undecided about which alternative would be best for them.

Finding no explanation of the concept of leasing elsewhere on the Internet that I thought was clear and thorough enough to help my website visitors, I decided to put one here. (It’s exactly the kind of information I needed to understand leasing when I started this business.)

Some of you may choose to become Fighting Chance customers and have us help you negotiate your next new-vehicle lease like an expert.

Our information package has all the instructions our customers need to negotiate the best lease, including the sample email/fax request they’d send to dealers to have them compete on price for their business. And when they’ve got all the key lease numbers from their best offer, but before they’ve signed anything, they can call us. We check their vehicle’s residual value against the number in the current Automotive Lease Guide’s Residual Percentage Guide, then take a calculator and run the lease numbers with them to be sure the monthly payment they’ve been quoted looks right.

I’d love to have you as a customer, but I’m glad to demystify leasing here for everyone who wants to break the code dealers don’t want us to know.

James Bragg

WHAT'S AUTO LEASING?

Think of it as long-term car rental.

You, the lessee, agree to make specified monthly payments in return for driving car a maximum number of miles over an agreed-upon time period — typically two to four years.

The entity that leases you the car is the lessor — a financial company that buys the car from a dealership and leases it to you. Most often, the lessor is the automaker’s captive finance company, but it could also be a bank or other independent financial institution. The transaction is arranged by the dealership, acting as a middleman between you and the lessor.

At lease-end, you return the car to the lessor, and you’re back to Square One. It’s not a “trade-in” because it’s not your car, it’s theirs. You’ve just paid to drive it around for a few years.

HOW SIGNIFICANT IS AUTO LEASING?

About 15% of new-vehicles are leased today. In the 1990s it was 20% to 25%, but in recent years two factors have combined to depress leasing’s penetration:

Residual values (the projected worth of new cars at the end of leases) have dropped significantly on a wide range of vehicles, increasing the amounts leasing companies must charge for depreciation and making lease payments more expensive.

Plummeting residual values on vehicles now perceived as gas guzzlers have resulted in crippling financial losses on leases written with much higher residuals 3 to 4 years ago. As a result, many financial institutions and some domestic automakers have either abandoned leasing or reduced their leasing exposure dramatically.

WHICH SOURCES OFFER THE BEST LEASES?

The most attractive, cost-effective new-vehicle leases almost always come from the automakers’ captive finance companies (Honda Financial Services, Toyota Motor Credit, Ford Motor Credit, etc.). That’s because the auto companies can subsidize their captives’ leases by taking some of the profit they make selling cars to dealers and using that money to inflate residual values and/or cut interest rates to reduce monthly lease payments. They don’t send that subsidy money to banks, credit unions or other financing entities, so it’s difficult for third-party leasing providers to compete on monthly payments with the automakers’ lease terms.

All dealers have access to other leasing sources. That’s especially critical to dealers for cash-poor automakers like Chrysler and GM that have either abandoned or reduced leasing dramatically for lack of available financing. But those other sources can be helpful to all dealers because many of them will lease to customers with credit scores below those required by the automakers’ captive finance companies.

You’ll find lots of “auto leasing companies” in the Yellow pages and on the Internet. Avoid them. They are just another mouth to feed — “middlemen” between you and the dealer. They must buy your vehicle from a franchised dealer, and they don’t have access to the subsidized leases offered by the automakers’ captive finance companies. Negotiate the best deal you can on your own. Then, if you wish to involve them, tell them the details and ask if they can beat it. They seldom will.

SHOULD YOU BUY OR LEASE?

The monthly payments will always be lower for leasing than for buying over the same time period. But leasing can be a great choice, a so-so choice or a terrible choice, depending on your situation and how you feel about spending your money.

Leasing makes the most sense for people who give a strong positive answer to one or more of these questions:

Do you typically get a new vehicle every 3 to 4 years?

Are you willing to make monthly car payments indefinitely?

Do you own a business that will be making those payments? (Your accountant may advise you to lease.)

Do you drive 15,000 miles a year or less?

Is it important to you to drive a car that’s covered by the automaker’s initial bumper-to-bumper warranty during all or most of the time you have it?

Do you need to minimize your monthly car payments for the next 2 to 4 years? (Leasing can be an attractive alternative in tough economic times like we're experiencing now.)

Do you want an extended “trial period” with a vehicle before committing to buy one (sort of like living together before getting hitched)?

By contrast, buying makes the most sense to people who answer one of more of these questions positively:

Do you buy new cars infrequently, typically keeping them 5 years or more?

Do you like to get the maximum value for every dollar you spend?

Do you drive significantly more than 15,000 miles a year?

Can you afford to pay off your car loan in 5 years or less?

Leasing is a good option for those who trade often and drive a moderate number of miles each year, especially if they can write off payments as a business expense. I also think leasing is a smart choice for anyone who gets a new car every three years because they’ll know all the costs up front and never have to worry about the value of their trade-in.

But leasing will never be the most cost-effective way to get around. If you lease forever, you’ll make car payments forever. The way to get the most value for every new-vehicle dollar you spend is to buy a reliable car, pay it off in a few years, then drive it several more years when you’re not making car payments.

WHAT ARE YOU PAYING FOR WHEN YOU LEASE?

Leasing seems more complicated than buying. Much of the confusion comes from leasing’s weird terminology, but the concept is simple and relatively easy to understand. To illustrate, let’s construct a lease and examine the basic elements to see what we’re paying for.

We’ll make the following assumptions:

1. The car you want has a retail/sticker price of $24,000.

2. You can negotiate a $22,000 transaction price. (In leasing lingo, that’s called “the agreed-upon price of the car.” It’s the price at which the dealer sells the car to the leasing company, and is the first piece of what they call “the capitalized cost.”)

3. The car is estimated to be worth $12,000 at the end of a 3-year lease. (That’s called “the residual value” or “lease-end value.”) It will typically be the lease-end buy-out price listed in your lease document.

The first (and largest) part of your monthly lease payment will cover the depreciation. In this example, that’s the difference between the $22,000 agreed-upon price of the car and its $12,000 lease-end value, or $10,000. You are borrowing that money and paying it off over 36 months.

The second (and next largest part of your payment) is what you and I call “interest” and leasing companies often call “rent” or a “lease fee.” It’s the equivalent interest charges on an auto loan. You are paying interest on two elements:

First, the depreciation of $10,000. You are paying this off, principal and interest, over the lease term. (This is comparable to buying a car for $10,000, putting no money down, and paying it off over three years.)

Second, the residual value of $12,000. You are not “buying” this part of the car’s value, but you are borrowing it and driving it around for three years. (The leasing company must pay the dealer the negotiated price of $22,000 to enable you to drive the car home.)

So in total, you are paying interest on (a) the depreciation balance of $10,000, which declines each year as you pay down the principal, and on (b) the residual value of $12,000, which remains steady over the lease term.

The third part of your monthly payment is the sales tax. In most states, the tax will be a percentage of your pre-tax monthly payment. (If your payment is $300 and the sales tax rate where you live is 7%, the tax will be $21 per month.) But in Illinois (and perhaps other states), you will pay the sales tax on the full negotiated price of the car, just as if you were buying — a significant disincentive for leasing there. (A few states, like New Hampshire and Oregon, have no sales tax.)

In most states you’ll pay the sales tax each month as part of your payment. But some states (e.g., New York and New Jersey) want all the tax money up-front for the entire lease term, which means you’ll either write a check for that total or add it to the agreed-upon price of the car to increase the capitalized cost of the lease, in effect borrowing that money and paying it off with interest over the lease term.

Check the law in your state to understand how leases are taxed there. No dealer would try to cheat you by adding more tax dollars to your lease than you’ll owe. They’d get caught doing that, and your state’s Attorney General would be on them like ugly on a baboon.

There are some additional one-time costs attached to leasing.

You will pay a lease “acquisition fee” (sometimes called a “bank fee” or “initiation fee”). This is typically in the range of $600 to $1,000. (As I’m writing this, Honda’s fee is $595. It can be higher on luxury cars.) This money goes to the leasing company, not to the dealer. It is non-negotiable.

There will also be a one-time “disposition fee” — usually a few hundred dollars — if you return the vehicle instead of buying it at lease-end. This amount will be listed in your lease agreement. It also goes to the leasing company and is non-negotiable.

These fees are the main ways the leasing companies make money. Financial entities have more expenses on leases than on purchases. If you don’t buy the car at the end of the lease term, they must pay someone to inspect it for excess wear and tear, fix whatever needs fixing, then ship it to an auction open to dealers who sell that nameplate. (Those dealers get “first dibs” on off-lease cars, most of which end up on the used-car side of their business as “factory-certified” used vehicles.) The acquisition and disposition fees help the leasing companies cover those costs.

If you exceed the mileage limit in your lease, you will pay an excess mileage penalty at lease-end to cover that additional depreciation. This is typically 20 to 30 cents per mile and will be specified in your lease agreement. Most leases are for 12,000 to 15,000 miles per year. (I have heard them as low as 10,000, but not lower.) You can request more miles if you need them, but higher-mileage leases require higher payments. It is less expensive to build the miles you’ll need into the lease initially than to pay a mileage penalty at lease-end. Try to estimate your mileage need realistically. If you exceed the lease limit significantly, you’ll write a big penalty check. But if you drive significantly fewer miles than the lease allows, you won’t get a refund.

Worth noting: Many of those leasing ads that feature low monthly payments are based on a mileage limit of 10,000 miles per year. (Check the fine print.) If they were figured on 15,000 miles, the payments would be higher.

Some leases may require a security deposit of one month's payment or more. That will be refunded at lease-end if the “wear-and-tear” on the vehicle is within specified “normal” limits. If the car has dents or other damage, or tires with less than a minimum amount of tread remaining, you will have to pay for repairs or new tires. If the security deposit is insufficient, you must pay the difference. So you should treat the vehicle even better than you’d treat your own car to avoid extra charges when you return it.

You should put the same insurance coverage on the car that you’d have if the car were yours. (Many leases stipulate minimum coverage requirements, which may be higher than you typically carry.) In addition, you should have “gap insurance” to protect yourself in the event that the car is stolen or totaled in an accident. That will cover the difference between what you’ve paid on the lease and what you will still owe, plus the residual value of the car. Gap insurance is built into the price of some companies’ leases, but is an extra cost item in others. Don’t drive a leased car home without having it.

You should also understand that signing a lease is like signing a car loan or mortgage loan. You are legally bound to make all those payments. If you terminate the lease early, you will owe the amount that hasn’t been paid. And beware of the dealer trying to sell you a new car before your lease ends who says, “We’ll take care of the last few payments.” Because what he isn’t telling you is that he’ll add that cost to the price of your next new car.

WHAT CAN YOU AND CAN’T YOU NEGOTIATE IN A LEASE?

Your pre-tax monthly payment is determined by three key elements: (1) The agreed-upon price of the car, the core of the capitalized cost; (2) the residual value; and (3) the interest rate, which leasing companies call the “the money factor.”

The only one you, the lessee, get to negotiate is (1), the price at which the dealer sells the car to the leasing company.

The leasing company (NOT the dealer) determines the residual value, so it can calculate how much to charge for depreciation. The reference “bible” leasing companies use to establish this value is the Automotive Lease Guide’s “Residual Percentage Guide,” which is published every two months, listing projected wholesale values of vehicles after 2, 3, 4 and 5 years. Residuals are stated there as a percentage of a vehicle’s original retail/sticker price (MSRP). They are realistic estimates of the price leasing entities will realize when they auction the leased vehicle to dealers selling that nameplate. (We subscribe to that Automotive Lease Guide publication. Our customers can call us to check the number they’ve been given.)

While the ALG’s residual numbers are realistic estimates, different leasing companies can place different residual values on the same vehicle. But all dealers quoting on leases from an automaker’s captive finance company should be listing the same residual value.

The leasing company also determines the interest rate, or “money factor.” Lessees with the highest credit scores get the best rates, just as they do when they are buying. If the rate is at or near the going retail market rate for car loans, chances are the dealer will earn some profit on it. But if it’s a factory-subsidized lease through an automaker’s captive finance company with a money factor well below the market rate, there’s usually no money in that for the dealer. The automaker may be charging you a lower rate then it’s paying for money.

HOW DO THEY CALCULATE YOUR MONTHLY PAYMENT?

It’s 5th grade arithmetic. You don’t need leasing software. Any cheap calculator will be sufficient, including the free one on your computer.

Let’s assume you want a three-year lease, 15,000 miles a year.

To calculate the lease payment, you need the following information, most of which you will get from the dealer:

The full retail/sticker price (MSRP) of the car.

The “agreed-upon price” you’ve negotiated for the car.

The amount of the drive-off check, with each element detailed.

The “final,” or “net,” or “adjusted” capitalized cost, with details of anything that’s been added to or subtracted from the agreed-upon price of the car to get to the total.

The residual value, which is always stated as a percentage of the vehicle’s full retail/sticker price (MSRP). Dealers will quote this either as a percentage or a dollar figure.

The “money factor” or interest rate the leasing company is using.

Now let’s calculate the payment using the base assumptions we made in the example in the section above titled “What Are You Paying For When You Lease?”

The retail/sticker price: $24,000.

The “agreed upon”/negotiated price: $22,000.

Assume that our “drive-off” check will cover the first month’s payment, the vehicle registration charge and the lease acquisition fee.

That makes the $22,000 negotiated price the “final/net/adjusted” capitalized cost.

The residual value: $12,000.

Assume the leasing company uses a “money factor” of .0025. (To convert it to an equivalent interest rate, multiply by 24. 0025 x 24 = 6.0%.) The 24 number factor is always used to convert a money factor to an interest rate. It is not related to the length of the lease. If you have the interest rate, divide by 24 to get the equivalent money factor (.06/24 = .0025).

To figure the monthly depreciation charge, subtract the $12,000 residual value from the $22,000 capitalized cost, leaving $10,000 in depreciation. Divide $10,000 by 36 months, and you'll get $277.78 per month.

To figure the monthly finance charge, add the $22,000 capitalized cost to the $12,000 residual value, for a total of $34,000. Multiply that $36,000 by .0025 (the money factor for 6% interest) to get a monthly finance charge of $85.00.

Adding $277.78 for depreciation and $85.00 for interest, the total monthly payment before tax would be $362.78. In most states, a sales tax will be added.

DO YOU GET THE INCENTIVE IF YOU LEASE?

Yes, but often in a different place.

Most automakers’ incentives today are stated as rebates or “customer cash,” with low-interest financing as a typical alternative. The consumer chooses between them. These programs apply to buying, not leasing.

Car companies will typically allocate the same incentive money to subsidize leases, lowering monthly payments. They give that money to their captive finance company, which applies it to one or more elements of the lease.

Let’s assume there’s a $1,000 incentive. In a lease, you may see it in one of three places, or in a combination thereof. It may be used to:

• Reduce the capitalized cost.

• And/or increase the residual value.

• And/or reduce (“subvent”, or buy down) the money factor/interest rate.

When you analyze the lease numbers, you will see the impact of that $1,000.

WHAT’S IN A TYPICAL “DRIVE-OFF” CHECK?

Don’t call this “a down payment.” It’s not. It’s just the check you write that enables you to drive the car home.

The drive-off check most Fighting Chance customers write includes three elements: the first monthly payment, the Motor Vehicle Department’s registration fee and the lease acquisition fee. If you don’t include the acquisition fee, it will be added to the agreed-upon price of the vehicle and increase the capitalized cost.

In states requiring all the sales tax money up front, some customers add that amount to the drive-off check, while others roll it into the capitalized cost and pay it over the lease term.

Anything you pay up front over and above these items, either in cash or in the value of a trade-in, is what you and I would call a “down payment” and leasing companies call a “capitalized cost reduction.” That additional money would pre-pay some depreciation, reducing your monthly payments. (On a 3-year lease, each extra $1,000 you pay up front would reduce your basic pre-tax monthly payment by $27.78 + interest.) Note: Cap cost reductions are taxed at the same rate as monthly payments.

Note that in many automakers' leasing ads featuring attractive low monthly payments, the “fine print” often lists a hefty required initial payment of $2,000 to $3,000 or more, much or most of which is a capitalized cost reduction. (Incidentally, you can often beat the monthly payment featured in those ads by negotiating a lower “agreed upon” price than the one assumed for the ad. That’s because automakers can’t assume a price so low that it will anger their dealers. Sometimes those ads are based on the full retail/sticker price.)

CAN YOU DEAL ON THE VEHICLE AT LEASE-END?

Many lessees purchase their vehicles when their leases end. They know the car and how it’s been treated and decide to keep it.

The residual value stated in their lease contract is the theoretical buy-out price. Some lessors may refuse to negotiate a lower price. Others may be more flexible.

In a factory-subsidized lease, the residual may have been inflated substantially, resulting in dramatically lower payments. If so, you’ve had the benefit of these lower payments for several years.

The result, however, can be a buy-out price at lease-end that’s dramatically higher than the vehicle’s market value. The lessor may say it was “pay me now or pay me later,” but the fact is they will net dramatically less than that residual value when they auction the car to dealers. So they may be open to negotiating a more reasonable price.

My advice: check the asking prices for similar vehicles on websites like cars.com and autotrader.com and figure you can buy them for about 10 percent less. Then make an offer for your car. If the lessor wants substantially more than your car’s market value, find another vehicle to replace it.

That’s Leasing 101. (The basics, demystified.)

Last word to the now-wiser: Only someone who just fell off the turnip truck would walk into a car store and ask, “How much a month to lease that car?” With a lease, you negotiate the price of the car first, just as you would if you were buying the vehicle. That's where your leverage is on the monthly payment.

The Fighting Chance information package contains everything our customers need to negotiate the best “agreed-upon price” for their leased car through a competitive bidding process, without walking into a car store. There are seven pages of instructions on what to do and when to do it, what to say to dealers and when to say it, each step of the way. Including a sample message they’d send dealers requesting price proposals and leasing number details.

And once they have all the key numbers on the best lease they’ve been offered, they can call us. We’ll check their vehicle’s residual value in the Automotive Lease Guide and run the numbers with them to be sure the monthly payment they’ve been quoted looks right.

If you like what you’ve read, why not have the folks who wrote it help you navigate through your next lease negotiation like a pro?

James Bragg