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Key Terms about leasing to be familiar with

Following is a list of terms that you need to be familiar with in order to understand the basics of a lease agreement:

Capitalized Cost: Sometimes also known as “cap cost” it is the principal part of a lease. Capitalization cost is the agreed-upon price of the car. This price includes the negotiated selling price plus any additional fees that you might want to add to your monthly lease payment (e.g. acquisition fee). Your monthly payment depends on this single factor.

Most dealers try to charge MSRP (Manufacturer’s Suggested Retail Price) of the car. But beware of this trap. Negotiate just like you are purchasing the car with cash. The lower you negotiate the price, the lower your monthly payment will be.

Capitalized Cost Reduction: Also known as “cap reduction”, this is basically the difference between the offered price of the car and the negotiated cost settled between you and the dealer. It includes anything that can lower the cap cost such as down payment, rebates, or trade-in allowances. Let us say you negotiated the purchase price at $30,000 and paid $5,000 as down payment, your cap cost is now $25,000 and cap cost reduction is $5,000.

Depreciation: Car depreciation is the amount of value a car loses over time after your purchase it. Depreciation is the primary and single biggest factor that decides the cost of leasing. The depreciation of a car depends on various factors such as price, quality, and mileage. Every car loses around 50% of its value during the course of a lease term.

When you lease a car, the rental fee you pay per month is actually the amount to off-set this depreciation over the course of a lease contract. Some cars depreciate more than others. So it is essential to understand how it is calculated. Following is an example:

Value of the car

  • At Purchase $45,000
  • After first year $37,500
  • After second year $30,000
  • After third year $21,000
  • Total Depreciation $24,000

From the above example, we can see that the vehicle has lost $24,000 of worth over a period of three years (36 months). Even if you are buying a car, your car will depreciate the same amount. So your leasing decision should be based on those vehicles that depreciate slower over time. You must choose a car that tends to hold a greater residual value. By leasing rather than buying a good car, you are not losing a massive chunk of cash on your new car. Car depreciation can also be reduced by comprehensive maintenance and avoiding modification.

Residual Value: Residual value is the official estimate of the wholesale value of the car after the end of a lease contract. The residual value is often called lease-end value or the lease-end purchase price. This value is calculated by taking into account the depreciation, demand for that car model, and the effect of expected mileage on the car’s value. Some companies also do this by consulting industry guidebooks like Automotive Leasing Guide. The residual value is expressed as a percentage of a car’s MSRP and not the selling price.

There is a rule: the higher the estimated value at the end of a lease, the lower the monthly payments.

Since the major portion of the payment is depreciation, it is essential to know how depreciation is determined. There is a formula to calculate it which includes residual value, the term of the lease and the capitalized cost. If you know these three values, depreciation can be calculated. In the example above, the residual value of the car after three years was $21,000, capitalized cost was $45,000 and let’s consider the lease term as 36 months.

Formula: Capitalized Cost minus residual value divided by Lease Term

Here is how it is calculated:

  • Capitalized Cost $45,000
  • Residual Value $21,000
  • Lease Term 36 months

Applying the formula to the above factors:

Capitalized Cost ($45,000) minus Residual ($21,000) = $24,000 So the total amount of depreciation after a period of three years is $24,000. Now divide this amount by the lease term (36 months) = $24,000/36 = $666.67 This is the amount of depreciation per month.

Money Factor: The money factor is also called the lease rate or lease factor. It is actually the interest rate similar to an annual percentage rate (APR) in a conventional loan. The only difference between the two is the way they are represented.

While the conventional interest rate is represented as a percentage (6.5%), the money factor is always represented in decimal form i.e. 0.00210. To convert it into a percentage such as a conventional interest rate, multiply the money factor by 2400. In the above case, it will be 5.04%.

Generally, the leasing agency purchases the car from the dealer. Technically you are driving the leasing agency’s car, so they expect you to pay the interest. This factor is a heavily manipulated term and it depends largely on the credit rating of the buyer. As a rule, the lower the interest, the lower is your monthly payment.

Mileage Allowance: It is the number of miles allowed to travel without penalty in a lease contract. This limit is usually specified as miles per year and it varies from 12,000 to 15,000 miles a year. Mileage also affects your monthly payments. Mileage is set for the leased vehicle to avoid excessive wear and tear thus ensuring a pre-determined residual value of the car at the end of the lease. In general, high mileage lease options result in higher monthly payments.

There are four types of car lease mileage options:

Low-Mileage leases: A low-mileage lease is lower than the standard lease. But it also offers much lower price than the standard lease. Usually, low-mileage lease starts from 10,000 a year.

Standard-Mileage Lease: A standard-mileage lease lies between a low-mileage lease and an extra-mileage lease. This type of mileage is the most common option for the lease buyers. A common standard mileage for a three-year lease is 36,000miles or 12,000miles a year.

Extra-Mileage Lease: This option is for the drivers that are regular commuters or they travel a lot. Extra-mileage leases can vary and can go way up to 100,000 miles a year for a 36-month lease term. This mileage option has significantly higher monthly payments and this amount increases as with extra miles. Remember that you do not get a refund if you do not use your extra miles.

In addition to all these mileage options, you can also purchase additional miles during your lease term and add them to your monthly payments.

Term: Simply put, the term is the duration of your car lease. The length of a lease is stated in months. Usually, most of the leases offer 36, 48, and 60 months lease contracts. But there are also long-term lease agreements that can go as long as 72 months. Some dealers also offer mid-year terms with a 42-month or 39-months duration. These terms are designed to bring the customers back to dealers at different times of the year in order to regulate the demand and supply of the lease market. A leasing company would always want you to have the car for the longer duration so they can earn more interest on their vehicle. But there are some lease contracts available for as low as 24 months. But the short-term lease has higher monthly payments because their residual value goes down faster in the first 24 months. Those who want to enter a short-term agreement want to change their vehicle often and that is why they pay slightly higher than the standard lease term. The rule for the term in a lease agreement is that the longer the lease agreement, the lower will be the payment. Therefore, the long-term lease agreements have lower monthly payments.

Lease terms nowadays are in accord with the official warranty duration of the car. This makes leasing more beneficial because the car is covered under warranty for its complete term.

Taxes: There are different taxes associated with auto car leasing. But their amount depends on which state you are living in. The states have their own tax values calculated on the basis of the overall cost of your vehicle. Some states tax only the part of the vehicle that you use i.e. the amount of depreciation.

Taxes are paid on a month-to-month basis but some states require the entire tax to be paid up front. For example, if you make a down payment (Capitalized Reduction Cost) on your car lease, you will be charged the state and local sales tax on your down payment amount. But in some states, you are also given sales tax credit if you trade in a vehicle at the time you lease a new car. There are also property taxes associated with the leased cars that are often paid by the lessee or the lease finance company.

Gap Insurance: When you buy or lease a new car, it starts to depreciate in value as soon as it leaves the car lot. In fact, most of the cars lose 20% of their value in their first year. When you purchase a new car with only a small deposit the amount of loan may exceed the market value of the car itself.

If your car is completely damaged due to an accident or totaled, then gap insurance covers the difference between market value of the car and the amount you actually owe on it. Most of the time gap insurance comes with your lease package but you can also opt for it separately.

Before you opt for it there are a few factors you should keep in mind. Gap insurance is only beneficial if you are making less than 20% down payment and financing for 60months or longer. As a rule, the harder your loan terms are the better it is to have a gap insurance.

Acquisition Fee: The acquisition fee is also called bank fee or administrative fee. This fee is usually charged by the leasing companies to arrange the lease. Sometimes also called the document fee, it can range from $400-$800 depending on the vehicle and leasing company. The acquisition fee can also be bundled into the monthly lease payments or paid up-front. It is occasionally rolled into the capitalized cost, therefore remains hidden.

Security Deposit: Some leases require a security deposit. This security deposit is a refundable sum paid to the manufacturer to pay for any damages to the vehicle at the end of the lease. Usually, the security deposit is equal to one month’s payment rounded up to the nearest $50. So if your monthly payment it $415, the security deposit will be $450.

The security deposit can also help in lowering your monthly payments. Multiple-security deposit is a strategy used to lower down the monthly payments. So if you have the cash and you are not investing it, this strategy can save you a good amount of money, sometimes even a $1,000! For example, if you agree to pay two fully refundable security deposits, the leasing company reduces the money factor (Interest rate). And a lower money factor leads to lower monthly payment.

Disposition Charge: It is a fee charged by the dealers to dispose of the car. Sometimes also called the turn-in fee, this fee is usually charged at the end of your car lease term if you do not buy the car. The disposition fee can range from $250 to $ 350 to cover the costs of the reconditioning the car for a resale. The fee may also be charged with “other charges”.

Drive-Off fee: It is the total amount of money payable when the lease contract is signed. This is the amount that you must pay to begin the lease. This fee includes various Department of Motor Vehicles (or similar state agency), security deposits, and taxes.

One-Pay Lease: It is a similar strategy to the multiple security deposits. In a lease, the buyers are aware of the total amount of expenses for the duration of the lease term. In a one-pay lease, you make all the payments upfront and the leasing company reduces your interest rate on the monthly payments.

Purchase Option: At the end of your lease term, you have an option to either buy the car or return it. You can buy the car at the end of your lease by paying the residual value plus any processing fees the manufacturer creates. Buying a car can be financially a good option in case you have to pay for the extra charges on the car. Since the vehicle is ‘rented’, it is better to pay for a car that is yours. For example, if you exceed the allowed mileage limit of 36,000miles by 10,000 miles and the leasing company charges $0.15 per mile, then you may accumulate $1,500 at the end of your lease. By purchasing your car, you do not have to worry about that additional surcharge.

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