Leasing Demystified

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THE FIRST THING to understand is that leasing is not renting. When you lease a car, you are arranging for the vehicle to be sold to a leasing company -- usually an arm of the manufacturer. The leasing company then lets you use it for a monthly fee over a set period of time, typically two to four years. (There is no limit, however.) When the term of the lease is up, you have the option: You can return the car to the dealer and walk away without paying anything else. Or you can buy the car for a prearranged lump sum, which is known as the vehicle's "residual value." (Click here for a full glossary of leasing terms.)

That's simple enough. What complicates things is the number of factors that go into calculating the monthly payment. When you lease a car, what you are paying for is the car's depreciation over the term of the contract, plus interest, taxes and fees. Depreciation is the difference between the car's value today (the price) and what it will be worth at the end of the lease (the prearranged residual value). As in a sale, the price (known in leasing as the capitalized cost) is negotiable. It can be cut automatically with a down payment or a trade-in. You can also negotiate the upfront costs, such as the acquisition fee and security deposit, to get a better deal.

Who Thought This Up?
Only after all those numbers are set can you calculate the monthly payment. Given a two-year lease, for example, the depreciation is the difference between the price negotiated today and the prearranged residual value 24 months from now. You then subtract any down payment or trade-in.

To calculate the monthly payment, you then take 1/24 of the depreciation, add in 1/24 of the total interest on the financing, and then add 1/24 of the sales tax, which is usually paid monthly instead of upfront.

As you can see, it gets very complicated, very fast. And it only gets worse when your dealer starts to massage the numbers. Each variable in the equation affects the others. In order to shrink the monthly payment, for instance, you have to change one or more of the other variables correspondingly. The smaller you can make that spread between the purchase price and the residual value, for instance, the less you have to pay back every month. Likewise, the more months over which you spread the lease, the lower the monthly payments.

Beware the Scam Artist
Dealers will always try to focus you on the monthly payment. There's a simple reason for this: If they can get you comfortable with a set, cheap-sounding number, they can manipulate the other variables -- the price, the interest rate, the residual value, or the term -- to boost their profit while keeping the payment where it is.

An example: A Florida woman leased a new Toyota Corolla, and thought she had bargained to pay a capitalized cost of $9,000 after her trade-in. She agreed to payments of $269 a month only to realize later that the unscrupulous salesman had added $4,000 to the cost of the car and stretched the payments out to five years to keep the numbers down. The tricky language of leasing camouflaged the inflated price.

The Federal Reserve, which oversees leasing, forces dealers to disclose all the terms of their leases in a one-page document. Pay attention to it. In How to Get the Best Deal, we will explain exactly how to interpret these numbers and where to go for comparisons. Then you can use one of our two Leasing Calculators to see if the numbers add up. It's up to you, of course, to demand the facts you need. But if your dealer won't provide them, walk across the street to someone who will.