While looking into a car lease, you might hear the term "residual value" mentioned by the salesperson. But what exactly is residual value? And what impact does value have on your overall monthly lease payments?
The 'Residual Value' of Leasing
Make Sure You Get a Good Lease by Checking This Number
Leasing is popular because it requires smaller down payments and lower monthly payments.
Let's start with a simple definition of residual value. In fact, let's look at the word "residual." Residual means the part left over after some of it has been taken away.
OK, so how does this apply to a car lease? Well, when you lease, you are paying for that portion of the car's value that you use. Here's how that works, in a nutshell:
You probably know that a new car's value drops once it is sold and driven off the lot, and that loss is known as depreciation. The longer a car is driven, and the more miles added to the odometer, the greater the depreciation amount will be. This depreciation is what is being "taken away" from the vehicle's new value.
A car's residual value is an estimate of the dollar amount your car will be worth at the end of the lease term. This estimate comes from the bank that will hold your lease contract.
Let's say you leased a vehicle with a manufacturer's suggested retail price (MSRP) of $20,000 for a three-year lease term, and this vehicle had a 60% residual value. That would mean the vehicle was projected to be worth 60% of the original MSRP at the end of the lease (60% of $20,000 is $12,000). The difference between the selling price and the residual is what makes up the bulk of your lease payment. For this example, let's assume you paid MSRP for the vehicle. Your lease payment would be based on the difference between the selling price ($20,000) and the residual ($12,000). This $8,000 difference would be divided over your 36-month lease — $8,000 divided by 36 months nets you a base payment of $222. Taxes, interest and fees would be added to this base payment to give you your overall payment.
Residual value: 60%
60% of $20,000 = $12,000
Selling price: $20,000
Selling price minus residual value: $20,000 - $12,000 = $8,000 (← this $8,000 is the depreciation amount and is the basis for your lease)
Lease length: 36 months
$8,000 divided by 36 months = $222.22 per month base payment (before taxes, fees, etc.)
Now, let's stick with that same example. What if the car you had decided to lease had a 45% residual value instead of 60%? Your $20,000 car would be projected to lose $11,000 of its value, reducing the residual value from $12,000 to $9,000. Your cost would jump from $8,000 spread out over your lease to $11,000. Here's how that would look:
Residual value: 45%
45% of $20,000 = $9,000
Selling price: $20,000
Selling price minus residual value: $20,000 - $9,000 = $11,000 (this $11,000 is the depreciation amount and is the basis for your lease)
$11,000 divided by 36 months = $305.55 per month (before taxes, fees, etc.)
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 at the end of the lease. 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 dealer lots), you will have to pay more for this car than for an identical used vehicle.
The bottom line is you should keep your eye on residual values as you shop for a car and when you negotiate your leasing contract.
So before you decide what kind of car you want to lease, consider which cars hold their value well. Here's an easy way to get the residual value of a vehicle you're eyeing: Send a quick note to the internet sales manager at the dealership that sells the brand vehicle you're looking for. He or she should be able to get you the information you'll need without too much fuss. It is worth noting that this person will need to know how long you intend to lease and how many miles you intend to drive in order to calculate the right value.
Or you can head over to the Edmunds leasing forum and look up residuals there.
The residual value isn't the only factor used to calculate 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.