Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Understanding the Confusing Art of Leasing a Car

Leasing a car -- it's not quite buying and not quite renting. Some people even believe it's just a sham put together by car dealers to sell you a car without ever actually selling you the car. But it's not that either.

Mainly, it's just an alternative to buying a car. And if you don't know much about it, it can also be very confusing. Which is why we're going to start you off with the basics.

Leasing a Car -- The First Thing You Should Know
The first thing you should know about leasing a car is that you're not leasing it from the car dealership. Once you and the dealer agree on a lease price, the dealer sells the car to a leasing agency (at the price you agreed upon), which in turn leases the car to you. From that point on, you deal solely with the leasing agency.

This set-up is one of the reasons leasing a car can feel so confusing. People are used to haggling with dealers about price and other terms in their contract, but when it comes to leasing a car, negotiations probably won't get you very far. Most factors of a lease agreement are already set in stone by the leasing agency. But don't dismay. You're not locked into the leasing company suggested by the dealer, and should feel free to shop around for a better offer.

But what if you're not sure whether or not you're getting a good deal? It's not an uncommon problem -- terms in lease agreements are very different from the terms in a purchase loan (what you agree to when you buy a car). While it's important to understand all aspects of your contract, the following terms can have the greatest impact on your monthly payments. And remember, if you don't understand something, always ask the dealer to explain it.

Initial Purchase Price
This is the only part of the lease deal that is actually negotiable. Every other major component (including the down payment, money factor, residual, security deposit and acquisition fee) is controlled by the leasing agency, not the dealer.

Why negotiate the initial purchase price? For the same reasons that you do it when you buy a car: A lower purchase price means lower monthly payments.

Residual Value
You probably already know that your car's value decreases the longer you drive it.

The amount your car is worth at the end of the lease term is called its residual value. If you're leasing a car with a high residual value, it means that the leasing company believes that the car will still have a lot of value after the lease ends. It also means lower lease payments each month.

Theoretically, residual value should equal the car's market value when the lease is up. Leasing agencies try to estimate this future value as accurately as possible, but the reality is it's difficult to predict with any certainty.

Money Factor
Since the leasing agency purchased the car from the dealer, you're technically driving the leasing agency's car. And not surprisingly, they expect you to pay interest. "Money factor" is just a fancy word for "interest."

The money factor is most often expressed in a lease agreement as a very small decimal, such as 0.00247 (although some dealers will quote it as a larger decimal -- 2.47 -- but don't be deceived, it's still the same number). Just like interest on a loan, the lower your money factor, the lower your monthly lease payments.

Using the money factor to determine how much interest you're paying may seem confusing at first, but it's actually one simple calculation. To determine your annual interest rate, just multiply the money factor by 2,400. (And yes, it is always 2,400). So our money factor of 0.00247 translates into an annual interest rate of 5.928%.

According to the Lease Guide over at LeaseGuide.com, that APR should be comparable to, if not lower than, local new-car loan interest rates.

Lease Term
Typical car leases last 24 months, 36 months, or 40 months.  A longer lease term allows you to spread out the cost of the vehicle and can lower the monthly payments, but can mess you around if it's so long that it outlasts your car's general warranty coverage. One of the main benefits to leasing is avoiding the headaches that come with maintaining a car that's no longer covered by a warranty.

Mileage Considerations
Car mileage also affects lease payment amounts. Typical mileage agreements are for 10,000, 12,000, or 15,000 miles, though there are also options for those driving above-average miles for work.

Lower mileage helps minimize monthly payments as it reduces depreciation and wear-and-tear on an automobile, but be honest with yourself when you make your decision. Going over the agreed upon mileage can become very expensive very quickly (such as $1 per mile over what was stated in the lease). Don't delude yourself into thinking that you can suddenly go from being a road warrior to driving less than 1,000 miles a month -- it's not worth the fees.

And if you still don't like the idea of leasing a car (but still need a set of wheels for less), check out the 5 Essential Tips for Buying a Used Car.