How car leases work
By Jude Wallis
A lease charges you for the value the car loses while you have it, plus interest on the money tied up in it. A $30,000 car with an $18,000 residual over 36 months depreciates $333.33 a month, the finance charge adds $60, and the payment is $393.33.
Monthly lease payment
$393.33
Money factor 0.00125 from a 3 percent APR.
- Depreciation
- $333.33
- Rent charge
- $60.00
- Payment
- $393.33
- Money factor
- 0.00125
Converted to a money factor as APR / 2400.
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In short
- The depreciation half is the capitalised cost minus the residual, divided by the term: $30,000 minus $18,000 over 36 months is $333.33.
- The finance half adds the two values instead of subtracting them, then applies the money factor. Here that is $60 a month.
- Add the halves for a payment of $393.33, before tax and fees.
- The money factor 0.00125 is 3 percent APR. Multiply any money factor by 2400 to read it as a rate.
- A high residual lowers the payment, because it is value you agree not to pay for.
You are buying the middle of the car's life
A lease is not a rental and it is not a purchase with a hole in it. The finance company buys the car at the capitalised cost, agrees today what it will be worth at hand-back, and charges you the difference over the term. On this deal that difference is the $30,000 cost against the $18,000 residual.
Spread over 36 months, that is $333.33 a month of pure depreciation. Every lease payment you have ever seen starts here, which is why two identical cars can lease for very different money: the one whose maker guarantees a higher residual is cheaper to lease without being cheaper to buy.
The finance charge adds the numbers rather than subtracting them
The second half of the payment looks like a mistake the first time you see it. The rent charge is the capitalised cost plus the residual, multiplied by the money factor, so here it is 30000 plus 18000 times 0.00125, which is $60.
Adding is right, because over the term the amount financed falls steadily from the cost to the residual. Their sum is roughly twice the average balance, and the money factor is built to be applied to twice the average. That is the same reason the conversion constant is 2400 rather than 1200, and how money factor works takes that constant apart.
Reading a lease quote in the order it is built
Ask for the capitalised cost first, because it is negotiable and everything downstream depends on it. Ask for the residual second, because it is not usually negotiable but it tells you how much of the car you are paying for. Ask for the money factor third, and convert it before reacting to it.
Only then does the payment mean anything. A payment of $393.33 is good or bad depending on which of those three numbers produced it, and a dealer can move the payment by changing any of them. Money factor against APR covers the conversion, and the car lease calculator splits any quote into its two charges.
What the lease does not settle
Mileage allowances, wear charges, disposition fees and the purchase option all sit outside this arithmetic and inside the contract. So does the decision that follows the term: hand the car back and you own nothing, which is the trade lease against buy prices against a loan. The identity here covers the payment itself, and car finance and depreciation covers what happens to a car's value over the years either choice runs. This is educational material, not financial advice.
Worked examples
A \$30,000 car with an \$18,000 residual
Capitalised cost $30,000, residual $18,000, 36-month term, money factor 0.00125. What is the monthly payment?
- Depreciation: 30,000 minus 18,000 is 12,000 of value used, over 36 months, which is $333.33.
- Finance charge: 30,000 plus 18,000 is 48,000, times 0.00125, which is $60.
- Payment: 333.33 plus 60 is $393.33.
$393.33 a month, made up of $333.33 of depreciation and $60 of finance charge.
A pricier car at twice the money factor
Capitalised cost $34,000, residual $20,400, 36 months, money factor 0.0025, which is 6 percent APR. What changes?
- Depreciation: 34,000 minus 20,400 is 13,600, over 36 months, which is $377.78.
- Finance charge: 34,000 plus 20,400 is 54,400, times 0.0025, which is $136.
$513.78 a month. The car cost about 13 percent more, but the doubled money factor pushed the finance charge from $60 to $136.
Common questions
Why does the finance charge use cost plus residual?
Because their sum stands in for twice the average balance over the term, which is what the money factor is scaled for.
Does a down payment lower the payment?
Yes, by cutting the capitalised cost. It is also unprotected if the car is written off, so many lessees keep it small.
What is a good residual?
A high one, as a percentage of cost, because it is the part of the car you are not paying to use.
Is this financial advice?
No. It is educational material explaining how a lease payment is built.
Keep reading
This page is educational material, not financial advice. The figures come from the formula shown and assume the inputs you enter hold for the whole term. Your own rate, fees, taxes and timing will differ, so treat the output as arithmetic to check a decision against, not as a recommendation.