Buying and Leasing a Car

Before walking into a dealership to buy  or lease a new car in New York it is very important to do your homework!

Introduction to The Money Rate Factor
The formula for calculating a lease payment is:

(Adjusted Capital Cost + Residual) * Money Factor + (Adjusted Capital Cost – Residual) / Lease Term

To most people this formula means little or nothing. By the end of this article, you will be calculating and understanding lease payments like you have been doing it your whole life. First we will explain some of the history of the money factor and then we will explain what this formula means.

If you ask someone what a Money Factor is, they will often say that it is related to the interest rate, which is true. But it all sounds so complex that most people just glaze over, nod their heads and pretend to understand. In many cases, the person trying to explain the money factor doesn’t really understand what it is either. Unfortunately, this complicated way of figuring the payments scares a lot of people away from leasing. How can you determine if you have gotten a good deal or not, if you have no clue how the payment was calculated and have no means to compare it to an interest rate on a loan. The government has passed a law called Regulation M this is supposed to ensure that the lessor gives the lessee full disclosure on the lease contract. Interestingly, this regulation does not require disclosing the money factor on a lease.

We agree that it may not be wise to spend a significant amount of your hard-earned money on something you really don’t understand. However, since leasing could potentially save you thousands of dollars, we want to take the time to explain the history behind interest calculations and the Money Rate Factor. Then, armed with this knowledge and understanding (perhaps even more understanding than many of the car salesmen you meet), you can make an informed decision.

The History Behind The Money Rate Factor

When you are leasing a vehicle, you can look at it as two getting two different loans from the lessor. Let’s say that you are leasing a vehicle with a cost of $25,000 and a residual of $10,000 at the end of four years. In effect, there is $15,000 in depreciation on this vehicle. Your lease payment can be divided into 2 parts:

Part 1: The $15,000 in depreciation over the life of the lease is similar to a $15,000 loan with a $0 balance.
Part 2: The $10,000 residual is similar to a $10,000 interest only loan.
One way to calculate the lease payment is to figure a $15,000 loan with a zero balance, and a $10,000 interest only loan and add the two amounts together. In this example we are going to use 6% as the interest rate.

Part 1:
If you plug a 4-year $15,000 loan at 6% interest into any loan amortization program, it will give you $352.28 as a loan amount. The “old school way” uses simple math to estimate a payment using the average balance of the loan to separately calculate the interest and the principal. These two amounts are added together to get the monthly payment.
Interest Calculation: The average balance for a loan that you are incrementally paying down to zero will always be the original amount divided by 2. So the average balance in this case is $7,500 ($15,000/2). Monthly interest on $7,500 is $37.50.

Principal Calculation: The monthly principal amount on a loan that is paid down to zero, is simply the beginning balance divided by the number of payments, or is this case $312.50 ($15,000/48).

The monthly payment on the first loan is $350 ($37.50 + $312.50). The $350 payment is slightly lower than the $352.28 calculated by the loan amortization program. This is because we used the Average or Median Balance rather than the Constant Yield Method used in loan amortizations.

Part 2:
The payment on a $10,000 interest only loan is simply, the amount borrowed times the annual interest rate divided by 12 to get the monthly amount. So $10,000 times 6% divided by 12 is $50 per month in interest.
Your total monthly lease payment would be $400.00 ( $350 from part 1 and $50 from part 2).

Understanding the Money Rate Factor

A mathematical formula was developed to make it easier to calculate monthly lease payments, resulting in what we call today the Money Rate Factor or Money Factor. The money factor is the annual interest rate divided by 2400. An interest rate of 6% is translated into a money factor of .0025 (6 / 2400 = .0025). So now we can revisit the formula for calculating a lease payment:

(Adjusted Capital Cost + Residual) * Money Factor + (Adjusted Capital Cost – Residual) / Lease Term

The formula has two parts:

Part 1: Interest Amount: (Adjusted Capital Cost + Residual) * Money Factor
Interest Amount: ($25,000 + $10,000) * .0025 = $87.50
Part 2: Depreciation Amount: (Adjusted Capital Cost – Residual) / Lease Term
Depreciation Amount: ($25,000 – $10,000) / 48 = 15,000/48 = 312.50
Monthly Lease Payment Interest Amount + Depreciation Amount:
$87.50 + $312.50 = $400
Entire Formula: (Adjusted Capital Cost + Residual) * Money Factor + (Adjusted Capital Cost – Residual) / Lease Term
($25,000 + 10,000) * .0025 + ($25,000 – $10,000)/48 = $400
You can see that the monthly payment of $400.00, calculated using the Money Rate Factor is exactly the same as the $400 calculated using the two separate loans concept. So the Money Factor is just a shortcut method for calculating a lease as a combination of a regular loan and an interest only loan. Now that you understand how it works, you can enter into lease negotiations equipped with the knowledge you need to compare interest rates between a loan and a lease. You can calculate very quickly, the interest rate that is being used on a lease by multiplying the Money Rate Factor by 2400. Since these figures can be difficult to multiply in your head, take a calculator with you , or develop a cheat sheet that looks something like this:

Interest Rate Money Factor Rate
4.0% .0017
4.5% .0019
5.0% .0021
5.5% .0023
6.0% .0025
6.5% .0027
7.0% .0029
7.5% .0031
8.0% .0033
8.5% .0035
9.0% .0038
9.5% .0040
10% .0042
With this knowledge, you should be able to make an informed judgment as to how much interest the lessor is charging you on a lease. Remember the interest rate is negotiable. Your lessor probably relies on several different financial institutions and may be able to get a better rate for you if you ask.

Determining the Money Factor and Equivalent Interest Rate on a Lease

As mentioned above, one of the interesting things about Regulation M, is that it does not require the lessor to disclose the money rate factor on a lease. In fact, we have rarely seen a lease contract that states the money factor on it. However, all of the information needed to calculate the money factor is required to be disclosed on a lease. You can use this information to calculate the interest rate on an existing lease, or to “check the math” of a dealer who is showing you a proposed lease contract.

You will need the following pieces of information to calculate the Money Factor on a lease:

Total Rent Charge
Lease Term in Months
Adjusted Cap Cost
Residual
The formula for calculating the money factor is: (Rent Charge/Lease Term)/(Adjusted Cap Cost + Residual)

Let’s assume that a dealer shows you a lease contract with the following information:

Total Rent Charge = $5,000
Lease Term in Months = 48 months
Adjusted Cap Cost = $31,000
Residual = $14,000
Money Factor = (Rent Charge/Lease Term)/(Adjusted Cap Cost + Residual)
Money Factor = (5,000/48)/(31,000 + 14,000)
Money Factor = .00231

Interest Rate = Money Factor * 2400
Interest Rate = .00231 * 2400
Interest Rate = 5.544%

For this lease, the Money Factor is .00231 and the Equivalent Interest Rate is 5.54%. We guarantee that most lessors will be amazed that you can make this calculation.

Summary

The concept of paying interest on two different loans may seem odd, but many of us have done the same thing with our home loans. Maybe you purchased a home for $200,000 but didn’t have enough for a 20% down payment. You put a little down, then realized your lending institution required you to pay a “mortgage insurance” payment every month. You couldn’t get out of this relatively expensive “PMI” unless your total loans was less than 80% of the value of the house. But, viola! You discovered you get a home equity loan to cover the difference. You take a home equity loan – an interest only loan – for a few thousand dollars and pay down the principal so you can get rid of the PMI. You figure that in a couple of years, you’ll be better off financially, so you’ll either try to pay down the home equity loan, or you’ll move to another house anyway. So it’s worth having an interest-only loan on the house to save the PMI fee.

The same kind of reasoning is what convinces many people to lease their vehicles. If you know that your financial status will be better in a couple of years, or if you know you’ll want to trade in your vehicle in a few years anyway, then paying down principal on only part of your vehicle and getting an interest-only loan on the rest, may be a very wise use of your funds.

Now that we have explained the history and theory behind the Money Rate Factor and how to calculate it, hopefully it will no longer be “mysterious” to you, and you will feel empowered to negotiate and understand a lease contract.