Anyone who has ever leased a vehicle or even browsed an advertisement for a lease has heard of the term "residual value." Yet, most people never get by that passing familiarity with the term and that can be costly if you are considering a lease. So, without pencils or calculators needed, here is your 5-minute primer on residuals and how they work in a lease.
The Future's So Bright…
The residual value of a leased vehicle is the lessor's estimate of what the vehicle will be worth at the end of your lease term. Sometimes referred to as the lease-end value, the residual value plays as significant a role in determining your payment as the rate.
A monthly lease payment is calculated using the difference between the vehicle's adjusted capitalized cost (e.g. the amount you agree to pay for the vehicle, including all incidental charges) and the predicted residual value of the vehicle. In other words, you repay the lessor for the price of the vehicle less the predicted residual value. In addition to being a key player in the calculation of the payment, the residual value also represents the minimum you should expect to pay if you elect to exercise your purchase option at the end of a standard closed-end lease.
By now, you've probably figured out that the higher a vehicle's residual is set, the lower your monthly payment will be. Of course, if you are leasing with the intention to purchase the vehicle at lease end, you'll wind up paying more when you exercise the purchase option.
Figure Me This
Residual values are usually figured as a percentage of the vehicle's MSRP, even if you successfully negotiate down the purchase price. For example, a $25,000 MSRP and a 50% residual factor will result in an estimated $12,500 residual value at lease end, even if you bargain the price down to $23,500.
18,000 (Adj. Cap. Cost) - 9,000 (Residual) = $9,000 (amt. to repay)
18,000 (Adj. Cap. Cost) - 10,000 (Residual) = $8,000 (amt. to repay)
Who determines residual values? Not the dealer! The lender behind the lease actually determines the residual values on all the vehicles it agrees to "finance" through leasing. The dealer has no ability to adjust the residual value of a vehicle short of switching to a lender that offers a more aggressive number.
To intelligently compare leases, a shopper really needs to know how the residual value offered by one lender stacks up against the residual value offered by another on the same vehicle. If you are choosing among more than one model, you should also consider determining which vehicle holds its value best. Ultimately, the one with the highest residual value will result in your lowest payment, all other things being equal. Cars from certain manufacturers yield high residual values model year after model year (like Lexus, Toyota, & BMW).
Virtually all auto lessors set their residual values using an industry standard as a baseline. Most begin with Automotive Lease Guide, a company whose business it is to track vehicle depreciation over time and produce an accurate set of residual value forecasts for every model available to you. The ALG residual value on a vehicle represents what a reconditioned clean vehicle should fetch at auction, so lenders begin with that number and make adjustments up or down to suit their particular risk preferences. ALG values typically reside at the conservative end of the spectrum and curious consumers can get their hands on these at www.leasewizard.com.
At the other end of the residual rainbow are the captive finance companies (e.g. Ford Credit, Toyota Motor Credit etc.), which typically offer higher than normal residuals to entice new lessees with lower payments. In the middle sit large banks, who will occasionally follow the captive companies in an effort to gain more lease market share. In the end, the consumer benefits from this competition, especially when the new car market is competitive (as it is today).
True market residual values will vary depending upon the particular model you choose, the lessor, the amount of miles you anticipate driving, and particular promotions being offered on that model. One way to shop residuals is to simply quiz the dealer's finance manager to find out which lenders are offering aggressive residual values along with competitive rates.
Before you get to the dealer, however, I recommend using LeaseWizard® Software to get both ALG and market residual values on virtually all makes and models sold in the United States. When shopping residuals, be sure to research similar type vehicles made by different manufacturers to take advantage of unusually high residual values being offered to aggressively promote certain models.
In all cases, be sure you determine how many annual miles come with the residual value package the dealer is quoting. The more miles you intend to drive, the lower the residual value! Be aware of seemingly awesome residual values, which have extremely low mileage allowances hidden behind them.
High Residuals Can Be Bad?
Believe it or not, there are times when you might not wish to have a high residual value. If you are planning to enter into an open-end lease, for example, you will be safer with a less aggressive residual value.
In an open-end lease, you are liable for the difference between the predicted residual value and the actual amount received by the lessor on the sale or auction of your vehicle at lease end. If the open-end residual value is artificially inflated to reduce the monthly payments, the shark will show up at lease end when the actual market value of the vehicle is lower and you owe the difference. (Under Federal law, this amount will usually not exceed the sum of 3 monthly payments).
If you are seriously considering a lease-end purchase, you may also be a candidate for a lower residual value because that is typically the amount you will be expected to pay for the vehicle. Of course, you must balance that possible saving against higher monthly payments.
A low residual value also makes good sense if you are leasing a vehicle for business purposes and you have the opportunity to purchase it for personal use at lease end. Provided the vehicle is actually being used for business, the higher monthly payments may be deducted as a business expense during the course of the lease, leaving a reasonable purchase option amount for you at lease end.
Unless you fit into one of those categories, however, you will likely find yourself shopping for a high residual value in order to obtain the lowest monthly payment. Manufacturers are aware of this and often "push" the residual value in order to advertise and deliver lower monthly payments. This usually operates to your benefit.
Michael Kranitz is an attorney and a nationally recognized consumer auto leasing expert. He is the author of Look Before You Lease: Secrets to Smart Vehicle Leasing and the creator of The LeaseWizard® Kit, the most popular auto leasing software and market data package available for consumers. Kranitz is regularly quoted in newspapers, magazines and online publications on consumer leasing issues.