This is the second of nine articles in our Blog Series Is Leasing Really Fleecing? In our previous article on How Leases Work, we stated that "interest" was one of the factors in determining the amount of the monthly lease payment. The time value of money is a significant factor in the pricing of leases. But, interest does not work the same way in leases that it does in car loans.
When a consumer leases a car from a car dealership, the leasing company pays the dealer the cash price of the car plus registration and fees, less any capital cost contribution paid by the consumer. So, the leasing company essentially "buys" the car from the dealership. In return, the leasing company obtains the right to collect the lease payments, and it gets the car back at the end of the lease. This represents an investment of the leasing company's capital, and it will not recoup that investment until the car is turned in at the end of the lease. An interest component is included in the lease payment to compensate the leasing company for tying up its capital during the lease term.
Unlike car loans, the interest rate is not disclosed to the consumer on the lease. Typically, however, the interest rate is comparable to new car interest rates for buyers with good credit. There is not much of a sub-prime leasing market; typically only consumers with good credit will be approved for a lease.
Although the undisclosed interest rate is usually about the same as it would be in a purchase transaction, the leasing customer will wind up paying more interest because of the way that the lease is structured. This is one of the reasons why leasing is usually more expensive in the long run.
In a car loan, each monthly payment covers a portion of the loan balance plus interest. Over the course of the loan, the balance is paid down to zero, and the interest component becomes smaller and smaller as the loan balance is paid down. But, in a lease, the consumer does not pay down the full cost of the car. The lease payments are applied to depreciation and interest. At the end of the lease, the consumer has to pay the Residual Value in order to keep the car.
In other words, the cost of the car is paid down at a slower rate in a lease than in a car loan. That is the reason that lease payments are lower than the payments in a car loan. But, because the car is paid down at a slower rate, interest is calculated on a higher balance in a lease, resulting in more interest being charged.
Additionally, while a consumer can usually reduce interest costs by making car loan payments in advance, there is no comparable way to save on interest payments on a lease. If you make your payments early, the only consequence is that the bank gets the free use of your money before your payment was due.
In our next installment, we will explain the charges that consumers can expect to pay at the end of their lease.
Series Installments: The links below will go live as each new article is posted.
Part Two: Do Leases Include Interest Charges?
Part Three: Understanding End of Lease Charges
Part Four: Leasing Games That Dealers Play
Part Five: The Cost of Leasing vs. Owning
Part Six: Leasing Pitfalls
Part Seven: Terminating a Lease Early
Part Eight: Is It Ever Advantageous to Lease?
Part Nine: Conclusion: Is Leasing Fleecing?