This is information you have to know about and oddly, car dealers will be happy to tell you when you show even the least bit of interest in purchasing or leasing another vehicle. It’s something that has caused the lease, something that is normally hated by financial professionals, to become a little more attractive.
An oversimplified explanation of a lease is that you’re paying the actual owner of the car a reimbursement fee (plus profits and other fees) so they don’t pay for the amount of value their car is losing while you’re using it.
We’ve all heard that cars lose a significant amount of value as soon as they leave the lot. We won’t quibble over actual percentages but the amount of value lost over the course of a lease can be significant. The value of the car at the end of your lease term is called the residual value. If you’ve never heard this term and don’t understand it, let’s fix that.
Residual value is the amount of money your car is worth when you turn it in. Let’s take a look at a 2011 Ford Expedition with a retail price of $37,825. If you were to lease this SUV and turn it in at the end of your 24 month lease, it’s residual value is estimated at $18,300. That’s a 51% loss in value in just two years. If you aren’t turning your Expedition in until your 60 month lease is up, the residual value is $11,025, a 71% loss in value.
Your lease payment pays a lot of that loss of value but the more important question may be, how does the leasing company know what a car will be worth in five years? The answer is that they don’t. They estimate and those estimates are always in their favor. The residual value of the Expedition may be closer to $15,000 in five years.
Because unemployment is high and consumers are more conscious of their finances, the demand for quality used cars is high. When demand is high, the value of used cars rises. What if the retail price of your leased Expedition was $37,825 back in 2006 and the residual value today, based on market conditions was $15,000? Your lease payment was calculated based on a residual value of $11,025.
The answer is a good one: You have $3,975 worth of equity if you hold your lease to maturity. This gives you a few options. First, you could purchase the car at the end of the lease period for $11,025 and sell it for profit. You could work with the dealership and leasing company to apply the equity to a new lease, get out of your lease early, or sell the car directly to the dealer and take a check home with you.
Of course there are no guarantees that you will have all of these options but they’re definitely worth exploring. What is definitely true is that if the value of your car is higher than the residual value of your lease, you’re coming out ahead.
This good news doesn’t automatically make a lease a cost effective financing option for your next car. Many people don’t want to own a car but if you do, it is better to finance a car than it is to lease and later purchase the car at the end of the lease term.
Tom Drake writes for Financial Highway and MapleMoney. Whenever he’s not working on his online endeavors, he’s either doing his “real job” as a financial analyst or spending time with his two boys.