Welcome to Automotive Leasing Part 2! Because I struggle with being concise, I’ve broken up my leasing posts into three parts. If you missed my first post, click here to take a look.
In Part 3 (coming soon!), I’ll go over all things related to the end of your lease term. Such as, turning in your car and walking away, versus buying it out and financing the residual. Also, fees and penalties that you may incur at the end of your lease contract. Stay tuned for that!
But here in Part 2, I’ll talk about down payments when leasing, and the always sexy concept of gap insurance. Let’s get into it!
First: Background on What Determines a Lease Payment
In response to my first post on leasing, I received a DM from a reader. She asked me to explain, conceptually, what determines a car’s lease payment. This is basically how I explained it to her.
In a lease, the monthly payment largely hinges on a car’s residual value. Basically, since you pay to cover the car’s depreciation during the lease term, a car that will be worth 60% of its original value at the end of the lease will usually be a better deal than a car that would only be worth 50% of the original cost. When you sign to take delivery of your shiny new car, you’ll already know exactly what the buyout price of your car will be at the end of your contract.
As a side note, this is why leases have a mileage limitation. The bank is able to set your car’s residual value, because they know how much your car will be worth when it’s three years old, with a known number on the odometer.
Your monthly lease payment is a portion of the difference between the car’s value when new and the residual value, plus interest charges and fees.
A down payment (or sometimes called a capitalized cost reduction in a lease context) doesn’t actually save much money in the long run when you lease a vehicle. Instead, it largely serves to prepay a portion of the total cost of your lease.
Here’s an oversimplified example. Let’s pretend you want to lease a $20,000 car. This car has a 50% residual value, so at the end of your contract, the car will be worth $10,000. Therefore, the total cost over a three year lease (ignoring sales tax, fees, interest charges, etc.) is also $10,000. If you make a $5,000 down payment, you’d make 36 monthly payments of $138.89. So, $5,000 up front, plus $138.89 x 36 = $10,000. If you made no initial down payment, your lease payment would be $277.78 over three years. $0 up front, and $277.78 x 36 = $10,000.
[Edit: To clarify, the above example takes interest charges out of the equation. Leases do involve interest rates (called the money factor), so if you did make a $5,000 down payment, it would slightly reduce the total cost of the three year lease compared to making no down payment at all. But lease money factors do not impact monthly payments in the same way that interest rates impact payments in a traditional car loan. In the above examples, the difference in the total cost of the lease would probably be, at most, a little over $100. Read on for why I don’t believe this small savings is worth it. But overall, whether you make a down payment or not, you’re spending essentially the same amount of money in total over the three year term.]
Clearly, making a down payment will lower your monthly lease payments. But, think twice before you do this. If your leased car is totaled or stolen, the car’s owner receives a settlement check from the insurance company. In the case of a lease, the owner is the bank. Since any down payment you’ve made on your lease isn’t treated like equity, like it would be with a traditional car loan, you’re unable to recoup any money that you’ve effectively prepaid on your contract.
For this reason, most financial experts will tell you that leasing makes the most sense when you make a minimal down payment, or no down payment at all. Your monthly payments are higher, but you minimize the financial risk of losing your down payment entirely in case something terrible happens.
In all automotive finance arrangements, be aware of the concept of gap insurance. When a car is totaled, gap insurance comes into play. It covers the difference between a car’s assessed value at the time of the loss, and the amount still owed on the contract or loan.
Gap insurance is important when you’re leasing, too. If you’re following the advice above and making a minimal (or zero) down payment, it is conceivable that you could owe more money on your leased vehicle than the car’s assessed value at the time of the loss. This is especially true if you’ve rolled taxes and fees into your lease payments as well.
Depending on the bank, gap insurance might already be included in your contract. Be sure to ask that question before you sign on the dotted line. If it’s not included, many dealerships will offer you a gap insurance policy as you’re inundated with add-on offers for extended warranty coverage and prepaid bumper fluid changes from the Finance Manager. Alternatively, check with your car insurance company. Many can also sell you a gap insurance policy.
Gap insurance is one of those things that you hope you’ll never need. But if you do, you’ll be happy you have it.
Thanks for reading!