by Ken Reigle

Created on: February 12, 2008   Last Updated: November 07, 2008

Before presenting the financial advantages and disadvantages of leasing a car, it is important to have an understanding of how leases work. Many factors contribute to the lease agreement, but for this analysis, studying a few major components will suffice.

A lease is a legal agreement requiring a consumer to pay for the use of a vehicle for a specified term. At the end of the term, the consumer returns the vehicle to the leasing company or optionally purchases it outright. The lease agreement determines the monthly lease payment, the total allowable mileage, and the consequences of returning the vehicle in an unexpected condition, such as damaged or with too many miles.

The primary factors used to calculate the monthly lease payment are the vehicle's price, the car's expected residual value, the money factor, and the duration. The basic formula is the car's price less it's residual value, amortized over the term using the money factor.

Here's how it breaks down.

A car's residual value is what the car is expected to be worth at the end of the lease term. A $20,000 car today will be worth much less after 24 months; perhaps $12,000, for example. This $12,000 is the car's residual value after 24 months of usage. After 36 months of usage, the car's residual value might only be worth $9,000.

The difference between the car's price and its residual value is the cost component of the lease. In the above example, the cost components are $8,000 and $11,000 for a 24 and 36 month lease, respectively. Lower cost components correspond to lower monthly payments.

Expected mileage per year also plays a factor in the car's residual value. The more miles a consumer expects to drive per year, the less expected residual value the car will have at the end of the lease term. This is not surprising, as a car with less mileage will fetch a higher selling price, assuming all other factors are equal. Most leasing companies use 12,000 miles per year as a base, and adjust upward depending on the consumer's anticipated usage. Leases with 15,000 or 20,000 miles will have higher monthly payments.

The leasing company requires the consumer to pay the cost component over the duration of the agreed upon term, plus a money factor, which is similar to the interest rate on a traditional car loan. Money factors are expressed differently than the Annual Percentage Rates (APR) on loans, and to calculate a lease's APR, simply multiply the money factor by 2,400.

If the leasing company quotes the money factor

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