Many customers focus on just one number when they negotiate a lease – the monthly payment – but that’s the wrong target. The key to getting a great deal on a lease is knowing the car's residual value and understanding its effect on the monthly payment.
The residual value is simply an estimate of the wholesale value of the car at the end of the lease term. Understanding where it comes from, and how it affects the price you will pay for a lease, is a bit more complicated.
Residual values, which are sometimes called lease-end values or the lease-end purchase price, are set by the company that is financing the lease, not the dealer. They are an expert guess as to what the car will be worth when the lease ends, and they are typically not negotiable. They take into account expected depreciation, historical demand for that model, and the effect of expected mileage on the car’s value. Experts also look at predicted market conditions, such as the price of gasoline, when determining the residual value. It is nearly always expressed as a percentage of a car’s MSRP, not the selling price.
While there is expert guidance available to lenders from companies such as Automotive Lease Guide (ALG), each lender puts their own spin on the values based on their appetite for risk and desire to help sell cars. More on why that is a bit later. For now, just know that not every lender will put the same residual value on a given car, and so not every dealer can offer the same deal.
Before we dive any further into the importance of understanding residual values, let’s remember how leases work. With a lease, you only pay for the depreciation that occurs on the car during the time that you have it, plus interest, fees, and taxes. For example, if a car costs $30,000 new with a residual price of $20,000 after three years, you’ll only pay $10,000 plus interest, fees, and taxes. That $10,000, plus incidentals, will be broken down into consistent monthly payments. The dealer is usually not financing the lease – there’s a financing company in the background providing the cash, and it’s that company that will hold the title to your leased car and set the car's residual value.
Here’s where the residual value comes into play in terms of the deal you can get. If that same car’s residual value is only $16,000, you’ll have to pay $14,000 plus taxes, fees, and interest over the life of the lease. If you’re looking at a car that holds its value well, the residual on our $30,000 vehicle might be $22,000, and you’ll only have to pay $8,000 plus incidentals over the term of the lease. The lower the difference between price and residual, the less expensive your payments will likely be.
Automakers love high residual values. They love them so much that there are coveted annual awards presented by ALG for the cars that hold the highest percentage of their value. (See table below)
ALG Residual Value Award Winners for 2017
Manufacturers frequently use high residual values to support new car lease deals, creating lower payments on slow-selling models. High residual values also prop up the used car market by keeping the price of used vehicles higher.Because the difference in selling price and residual value is less, lenders can offer lower payments that will entice more customers to those models.
Independent lenders, on the other hand, like to see low residual values. High residuals add risk for lenders. If market conditions force them to resell a car below its residual value, they lose money. Unless it is a deal subsidized by a manufacturer, most lenders prefer to have lease customers pay more in depreciation and interest and, in turn, reduce their own exposure to market fluctuations.
How you as a consumer feel about a vehicle's residual value depends on your financial and car-buying goals. If you want the most car for the least cost, and are certain that you will turn the vehicle in at the end of the lease, you will want one with a high residual price.
If you're thinking of buying the car at the end of the lease, you'll want to look at vehicles with lower lease residuals, as you'll usually be able to purchase it for about that price at the end of the lease term.
Many consumers are confused by all of the numbers involved in a lease, and dealers can take advantage of that barrage of information. For instance, many think that they have to pay full sticker price to lease, and that is simply not the case. The best deals for consumers are a combination of a low selling price, a high lease residual, and a low money factor (which is another way of expressing the interest rate that the lender will charge).
Experts suggest that you negotiate the best price possible on a car before you ever mention that you plan to lease. In that way, you can ensure the lowest possible spread between the price you pay and the preset residual value.
You can recover some money at the end of your lease if the value of the car is significantly higher than the residual value. Choosing a car that holds its value and keeping the mileage well below the lease's mileage limit are two ways to maximize your chance of that happening.
Unsure of whether leasing is right for you? Learn whether you should buy or lease your next car.