In the lease formula it looks like I’m paying interest on the sum of cap cost and residual?

In the lease formula, it looks like I’m paying interest on the sum of capital cost and residual? The short answer is no, you aren’t. Short answers never provide all the details so read on and you’ll be able to understand just what you are paying for and how the interest costs are calculated.

Two Differences between Leasing and Buying
First off, leases don’t use the same interest rates that traditional car loans use because the nature of the lease is different. Leases use something called the money factor. The money factor is related to the interest rate. You can multiply it by 2400 to get an interest rate, but how that rate is actually used in calculations is different. The difference means that the money factor is much more straightforward and easy to use in calculations. Additionally, the finance charge can sometimes be referred to as the rent charge.

Secondly, when you are leasing a car you are paying for the difference between the capital value and the residual value. This the cost of the lease. Likewise, when you buy a vehicle you are paying for the entire cost of the vehicle. If you finance it, you are paying interest on the total cost of the vehicle.

Money Factor vs. Traditional Finance Charge
The money factor was created to properly address a fundamental difference between leasing and buying, but it also introduces the ability to easily calculate payments. There is no need for complicated formulas. One fundamental difference is that while you are paying for the difference between the capital cost and the residual, finance charges are calculated on the average value of the vehicle, sometimes also called amount financed. For leasing payment purposes, this is the average between the capital cost and the residual.

It makes sense. When you buy a new car, payments are amortized, but in the end, you have paid an interest charge that is based on the average amount owed over the life of the loan. If you finance \$20,000, your finance charge would be roughly based on an average amount owed of \$10,000. If you lease a car with a capital cost of \$20,000 and a residual value of \$12,000 then the average amount financed would be (\$20,000 + 12,000)/2 which is \$16,000.

When you look at your paperwork, it might appear like you are paying finance charges on both the capital cost and the residual cost, but you aren’t. The money factor has the divided by 2 calculation built into it. Building that operation into the money factor improves the ease of calculating the finance charge for the lease.

The Money Factor Demystified
Now is a good time to talk about what numbers make up the money factor. As already mentioned, the money factor can be multiplied for 2400 to come up with an interest rate, but let’s talk about how that 2400 was arrived at. Let’s look at a couple of formulas. Rate=MF*2400. Likewise MF=Rate*(1/2)(1/12)(1/100) or (1/2400).

Let’s talk about those numbers and what they mean. The 1/2 is used for finding the average amount financed. Remember that the sum of the capital cost and residual cost has already been computed so we need the average of those two numbers. Next, the 1/12 signifies that there are 12 months in a year. We need to convert a yearly cost into a monthly cost. Finally, the 1/100 is needed to convert a percent into a decimal for calculation purposes.

Calculate Your Own Lease Finance Charge
Let’s go back to our previous example of a car with a capital cost of \$20,000 and a residual value of \$12,000. Let’s now assume an interest rate of 3% for ease of calculation. We know from calculations that the money factor is 3/2400 or 0.00125. Let’s see how much the finance charge will be. That’s \$32,000*0.00125. That’s \$40.00. You are done calculating it. You can even run that calculation through a simple dollar store calculator because it’s that easy.

Feel free to check the results. The average amount financed is \$16,000. Multiply \$16,000 by 3% and then divide by 12 for a monthly payment. In the calculator, you would do \$16,000 x 0.03/12. Your answer is \$40. It’s easy to see why the leasing industry is using the money factor to calculate lease finance charges.

Calculate Your Full Lease Payment Easily
The rest of the lease payment calculations are just as easy. On our example lease, the lease cost is \$8,000. For a 36 month lease, that’s just \$8000 divided by 36. You get \$222.22. Add on the \$40 of finance charge and your lease payment before taxes is \$262.22 a month. Easy calculations and you can perform all of them on a cheap calculator.

This is a longer answer, but now you know that you are not paying interest on the sum of the capital cost and residual value of your lease. Knowledge is power, now you more fully understand your lease payment and how it’s calculated. Use this power to get the best deal possible.