Leasing Tips

When you lease a vehicle, you might hear the term residual value mentioned by the salesperson. What is residual value? And what effect does it have on your lease payment?

The residual value is the amount you can buy the car for at the end of the lease, if you decide you want to purchase the car. It also is an important number in the lease equation, directly affecting your monthly payment. So, where do they get the residual value? And what does it mean?

Let's start with a simple definition of residual value. In fact, let's just look at the word residual. Residual means the part that is left after some of it has been taken away.

OK, so how does this apply to leasing? Well, when you lease a car, you pay for that portion of the car's value that you use. In other words, let's say you leased a $20,000 car for three years, and it was worth $10,000 at the end of the lease. In this scenario, you've used $10,000 worth of the car's value, or 50 percent of the car's original price. Your payments would be $10,000 divided into 36 monthly payments of $277 (plus interest, tax and related fees).

Now, let's stick with that same example. What if the car you had decided to lease didn't lose 50 percent of its value over three years? Instead, it lost only 35 percent of its value. Then, your $20,000 car would only have lost $7,000 of its value. Your monthly payments would be $194 (plus interest, tax and fees).

You can see from these two examples that the residual value has resulted in a much lower monthly payment. And when you're leasing, monthly payment is where it's at. Right?

Well, not always.

Say you decide to lease because you don't want to make a large down payment, and you want low monthly payments (this is one of the advantages of leasing over buying). However, three years go by, and you have developed an attachment to the car. So much of an attachment, in fact, that you decide to buy the car. If the residual value has been artificially inflated to give you a low monthly payment (this is called a subvented lease and is done by manufacturers to move slow-selling cars off their lots), you will have to pay more for this car than for an identical used vehicle.

So, the bottom line is, you should keep your eye on residual values as you shop for a car, and also when you negotiate your leasing contract. But how can you do this? After all, is the residual something the consumer can negotiate? Where do these values come from?

The banks that issue the lease contracts set residual values. The residual value is their best guess as to what the car will be worth at the end of the lease. They base their projections on data from past models and a prediction of what consumer tastes will be.

In most cases, you can't negotiate the residual value. However, you can — and should — shop for a lease based on the residual value. Going back to the example at the beginning, it is obvious that the less a car depreciates, the less you pay to use it. This is why, when you lease a car, you can afford to drive a more expensive car than when you buy one. You might hear car salespeople say, "You can drive more car, for less, when you lease."

Does this sound too good to be true? Well, here's why they say that.

If you lease a $35,000 German luxury car for three years and it has a residual value of 70 percent, it is worth $24,500 at the end of the lease. It has only lost $10,500 of its value, and you will have paid $291 a month (plus interest, tax and related fees). Now compare that to, say, a $25,000 American-made minivan that has a residual value of 50 percent after three years. The minivan has lost $12,500 of its value, and the monthly payment would be about $347 a month.

(I should stress that the figures I'm estimating here do not include interest, which is a big part of the lease payment. For purposes of comparison, the German luxury car, leased at 7 percent interest rate, with $0 down payment, would include $173 worth of interest each month, for a total of $465. And that still doesn't include tax. Additionally, that residual figure of 70 percent after three years is probably non-existent; I used the number to prove the point.)

As you can see, the residual value is an important part of the leasing equation. So before you decide what kind of a car you want to lease, you should consider which cars hold their value well.

If you want to check the residual rates of current model cars, look in the Black Book, which is put out each quarter. The Black Book may be available at your local bank in its auto loan department. Online, check the Web site for the Automotive Leasing Guide. Residual values are automatically inserted and monthly payments are approximated.

Remember that the residual value is different each year. It might be 70 percent after one year, 60 percent after two, 50 percent after three, and so on.

The residual value isn't the only factor influencing your lease payment. But it is one of the most important points to consider. Watch it carefully, and you'll enjoy driving your leased vehicle a whole lot more.