Understanding Residuals and Depreciation

To better understand leasing consider the following:

First, all vehicles depreciate. That is to say, that all vehicles lose value over time. As a rule of thumb, a vehicle will lose 50% of its value in 3 years. For example, a $30,000 vehicle is worth $15,000 after 3 years.

Second, the remaining value (as the $15,000 in the example above) is referred to as the "residual value." It is also referred to as the "future value" - what the vehicle is projected to be worth in the future.

Residual values are expressed in a percentage of its original MSRP. This value is typically based on 3 years. That would mean that a vehicle with a 48% residual is projected to be worth 48% of its original MSRP after 3 years. If the vehicle had an MSRP of $10,000 then it would be projected to be worth $4,800 after 3 years.

A residual value is a guess. No one can be sure what a vehicle will actually be worth in the future. If you purchase a vehicle today, you have no guarantee regarding its future value. So you are taking a risk regarding it's trade value.

Often a consumer will be trading a vehicle and will owe more on their loan than the vehicle is worth. For example, the vehicle is worth $10,000 but there is $12,000 outstanding on the loan. This situation is referred to as "negative equity." When you owe more than your vehicle is worth. In this case, the consumer has $2,000 negative equity. This money must be paid when the vehicle is sold or traded. A consumer will either pay this balance with cash or add it to their next loan. This is referred to as "rolling over negative equity."

This is the most costly part of purchasing a vehicle - depreciation. The consumer typically pays little attention to future value and will lose thousands in depreciation.

What if you could be guaranteed not to lose any money? What if the future value of your vehicle could be guaranteed? What if you only paid for the depreciation on a vehicle, instead of the entire amount of the vehicle? What if the bank took the risk regarding the vehicle's future value? What if you had an option after 3 years to walk away from the vehicle or choose to pay the remaining value?

That would be a lease.

Under the terms of a lease, a consumer pays the depreciation on a vehicle plus interest. The residual is guaranteed. The consumer has the option of either paying the remaining balance and owning the vehicle outright or walking away.

The benefits are tremendous. The monthly payment is typically 25% lower as compared with financing. The consumer only pays sales tax on the payments instead of the entire vehicle. The consumer generally leases during the term of the new car warranty - hence there are little if no upkeep costs. And best of all, there is no risk of trading the vehicle. The consumer has not paid for the vehicle in full only to hope to get some back during a trade. And if the vehicle has not been paid in full, there is no risk of negative equity.