The other option to buying a car is to lease it. Leasing a car is basically renting it for a period of time (the term), usually 2 or 3 years (24 or 36 months).

Of course, a vehicle is an asset with a variable value. When you rent a car from Enterprise for a few days, its value doesn't change much, so you just pay for the service of renting the car. With a lease, you have the asset for years, and its fair market value can change substantially during that time, so financing becomes relevant.

A vehicle lease is financially structured like this. The y-axis is dollars.

                 ___ $ msrp
                ░
                ░___ $ adjusted capitalized cost
               ╏░
               ╏░
Depreciation -<╏░___ $ midpoint
   Cost        ╏░
               ╏░
               ╏░___ $ residual
                ▓
                ▓
                ▓
                ▓
                ▓
                ▓
                ▓
                ▓
                ▓
                ▓
                ▓
                ▓
                ▓
                ▓
                ▓
                ▓
                ▓___ $ 0

Start with the sticker price of the vehicle, that's MSRP. It's how much the vehicle is worth at the start of the lease.

Subtract any discounts & incentives and your down payment (if any). That is adjusted capitalized cost. Don't worry about why it's called this, just understand that is what that number means.

The residual is a prediction of the fair market value of the car at the end of the term. Cars are depreciating assets and lose value as a function of time, mileage, wear, etc.

The last number is the money factor. This is a small decimal like .00329 that determines how much you pay in rent to the lessor. If the number is bigger you pay more, smaller you pay less.

When you lease a car you pay the lessor for two things:

• The depreciation of the vehicle over the time that you have it
• Rent charges for the privilege of renting the vehicle

There's also taxes and insurance but we can ignore those for now.

To understand depreciation charges, first consider that the lessor still owns the vehicle that you're renting throughout the term. That's their asset. They could have sold it for cash (which does not depreciate), or used it for its useful purpose (and bore the depreciation cost themselves). Instead they're letting you use the asset during the term. During that time the fair market value of the car is decreasing. When they get their car back at the end of the term it will be worth less than it was at the start. Therefore it's only fair that they be compensated for that depreciation. The most fair way to do this would be to assess the fair market value of the car each month relative to the previous month, and charge you the difference. However, business is done with contracts and most people who want to lease cars would not be happy about a company getting to decide what to charge them each month on the fly. They want to agree in advance on what they will pay each month. Thus it is necessary for the lessor to make a prediction about how much the car will depreciate over the term and decide how much they think it will be worth at the end of the term - the residual. Once you understand that, calculating how much you pay in depreciation is easy. It's (adjusted capitalized cost - residual). In the graph this is represented as “depreciation cost.” Note that this is not equal to the actual depreciation of the vehicle! That would be (MSRP - residual). The incentives & down payment are working in your favor here.

The other part is the rent charge. This is charged to compensate the lessor for the privilege of using the vehicle. Basically this is the profit for the lessor. Calculating this quantity is where people usually get tripped up in lease math because it's not obvious why it is calculated the way that it is. To calculate how much you pay in rent in total, it's (adjusted cap cost + residual) x money factor x term. It's calculated this way because the money factor itself is defined as APR/(12*2). The 2 in the denominator of the money factor divides the sum of adjusted cap cost and residual to get the midpoint shown in the bar chart (the average between the residual and adjusted cap cost). Why is the money factor defined this way? Because the “principal” (to use loan terms - this is not a loan) of the asset - ie the car's value currently being held by the lessor - decreases from the adjusted cap cost down to the residual over the lifetime of the lease, and the intention is to charge rent on the total value of the asset currently being leased at any given time. That value is constantly changing over the term, but ends up being roughly the same as the midpoint. But returns are usually defined in percent. So they decided it was easier to take the APY they wanted, divide it by 12 to get monthly, then divide it again by 2 for reasons unknown to anyone. They could have clearly explained that rent is charged on the average of the adjusted cap cost and the residual, but instead they included the 1/2 factor in the definition of the money factor. The upshot of this is that the midpoint defines how much rent you pay - anything that lowers the midpoint will reduce the rent charges. Also the APR is the money factor * 2400, I have to say that because it's how every website “explains” what the money factor “is”. If you write anything about car leases you have to say that.

Obviously to get the total amount you pay over the lifetime of the lease, add the depreciation cost and rent charge. To get it monthly divide by the term (in months).

That's it. That's all there is to lease financing. It took way too long for me to figure this out. The math has numerous interesting consequences. Note that any discounts off the MSRP (and your down payment, if any) work double duty to reduce both the depreciation cost and the rent charge. Also note that the rent charge cannot be completely eliminated even if you prepay the entire lease.

The biggest difference between leasing and buying is that at the end of the term, you have two options:

1. Return the car to the lessor
2. Buy the car at a predetermined price (this price is almost always the same as the residual)

This sets up an interesting tradeoff. If at the end of the lease the FMV of the car is more than the residual, you can buy the vehicle and “make” money. So for example if the residual is $55k and at the end of the term the FMV of the car is actually $65k, you can buy the car at $55k. Now you have $10k of equity in the car. People tout this as a benefit of a lease. Of course, you need to decide the break even point; maybe you can make $5k of equity buying the car, but getting that $5k out of the car may not be worth the time and hassle of selling it.

On the other hand if the FMV of the car at the end of the term is less than the residual, it's in the lessee's best interest to return the car. At that point the lessee has compensated the lessor for the depreciation cost of the vehicle plus some amount of rent charges, but if the asset is worth substantially less than its predicted residual, it's possible the lessor makes little profit, no profit, or loses money on the whole lease. As you might imagine, lease contracts typically try to ensure this does not happen, either by setting a conservative residual or by charging a lot in rent (high money factor). In either case the lessor will usually sell the car as a certified pre-owned (the fate of most returned leases).

The nice thing about this is that it allows lessors to get a new vehicle every few years while the lessor takes the depreciation risk. The downside is that if you lease repeatedly you're constantly paying for the depreciation of new cars (plus rent), which is most rapid in the initial years of their existence, so in the long run it is substantially more expensive than buying a car and owning it for a long time. This is why the most sound financial advice is to purchase a vehicle that is likely to retain its value well (such as a Tacoma) rather than lease. However the benefits may be worth this cost to some people or in some situations.

As an example of such a situation, if there is a high risk of the vehicle being worth very significantly less than a normal car over a 2-3y time frame, it can make sense to lease that vehicle and pay a premium to the lessor in exchange for them shouldering the depreciation risk. Vehicles produced by new companies that could go out of business during the term, or using new and unproven technologies, are illustrative examples.

Another consideration is that car is usually covered by the manufacturer warranty during all or most of the term. By repeatedly leasing vehicles the lessee has a car that is always under warranty. This can free them up to drive cars that they may not otherwise buy for reliability reasons.

The final major thing to consider about leases is that they always have mileage limits. These are expressed in miles/year but they aren't evaluated on a yearly basis, just at the end of the term. Any overage on the allowed mileage is usually charged at a relatively high rate, commonly $.30/mile, although this is sometimes negotiable. These mileage allowances are always factored into the residual, since mileage is one of the factors affecting the value of a car. There's usually stipulations about excess wear and tear as well.

Other things to know about leases:

1. The lessor owns the vehicle throughout the lease period.
2. You insure the vehicle on your policy.
3. Down payments are not required.
4. If the vehicle is totaled during the lease period, you lose any down payment.