Mastering the Art of Car Leasing: Understanding the Constant Yield Method
Written By
CarOracle Experts
Published
Jun 2, 2023
Master the Constant Yield Method in car leasing to understand its impact on monthly payments. Explore this comprehensive guide for expert insights.
Introduction
Understanding the calculations behind your car lease payments can be puzzling. In the U.S., these calculations are commonly done using the "Constant Yield Method." This article will help you understand this method, how your monthly payments are calculated, and the factors influencing the cost of your lease.
The Constant Yield Method, also known as Lease Amortization Schedule, is a technique for calculating lease payments. It spreads the total lease cost, which includes depreciation and finance charges, over the lease term.
How Does the Constant Yield Method Work?
This method breaks down into three components: Depreciation, Interest, and the Money Factor.
Depreciation: The biggest part of your lease payment covers the vehicle's depreciation - the expected loss in value during the lease term. It’s calculated by subtracting the car's residual value at lease end from its initial cost.
Interest: The interest is charged on the sum of the initial capitalized cost and the residual value. Contrary to some misconceptions, this interest portion remains constant throughout the lease term.
Money Factor: Represented as a small number (like 0.0025), the money factor can be converted to an equivalent APR by multiplying it by 2,400.
Unpacking an Example
Let's use a practical example to illustrate how this all comes together. Meet Sally. Sally is planning to lease a brand new car, with a Manufacturer’s Suggested Retail Price (MSRP), including destination, of $30,000. After some negotiation, she manages to get the dealer to reduce the price by $500, bringing the capitalized cost down to $29,500.
Now, the leasing company sets the residual value of the car after three years to be 60% of the MSRP. This means that the expected value of the car at the end of Sally's lease is $18,000 (60% of $30,000).
Depreciation Component: To calculate the depreciation component of Sally's lease, we subtract the residual value from the capitalized cost: $29,500 - $18,000 = $11,500. Since Sally's lease term is 36 months, we divide the total depreciation by the number of months: $11,500 / 36 = $319.44. This is the portion of Sally's monthly payment that covers the car's depreciation.
Interest Component: To calculate the interest component, we first need to find out what the Money Factor is. In this example, let's assume that the leasing company has set the money factor to be 0.00125. To convert the Money Factor to an equivalent APR, we multiply by 2,400. Thus, Sally's interest rate is 0.00125 * 2,400 = 3%.
The interest charge for a lease is calculated on the sum of the outstanding capital cost and the residual value. Therefore, for Sally's lease, this sum would be $29,500 (capital cost) + $18,000 (residual value) = $47,500. The monthly interest payment would then be this sum multiplied by the Money Factor: $47,500 * 0.00125 = $59.38.
So, Sally's total monthly payment is the sum of the depreciation and the interest payments: $319.44 (depreciation) + $59.38 (interest) = $378.82.
This simplified example should give you a clear understanding of how your monthly lease payment is calculated using the Constant Yield Method. It's essential to remember that this amount excludes tax, fees, and any other costs that might be included in your lease contract.
Understanding these calculations can also be beneficial if Sally decides to buy the vehicle before the lease ends. In that case, she'll need to pay the remaining depreciated value plus the remaining interest, which can be calculated using the principles we just discussed.
Remember, leasing companies use methods like this to spread the cost of your lease evenly across the lease term. As a customer, understanding how these calculations work can give you a clearer picture of what you're paying for.
Impact on Early Lease Buyouts
https://www.caroracle.com/auto-leasing-programTaking our example a step further, let's consider a scenario where Sally decides to buy the car before the end of her lease term. The first thing to note here is that the specific terms and conditions of early lease termination can vary widely between leasing companies, and this information will be stipulated in the lease agreement. Therefore, it's crucial that Sally, or any lessee in a similar position, thoroughly understands their lease agreement.
Typically, if a lessee decides to purchase the car early, they would be required to pay the remaining balance on the lease. However, as interest is calculated and applied monthly, the outstanding balance will primarily consist of the remaining depreciated value (the principal), since future interest hasn't been accumulated yet.
This aspect might seem beneficial for savings at first glance, especially if the decision to buy is made early in the lease term when a substantial portion of the depreciation cost remains. However, it's not quite that straightforward.
Leasing companies often include early termination fees in their contracts to protect their financial interests. These fees can sometimes be quite substantial and could significantly affect the overall cost of purchasing the car early. So, while the removal of future interest might appear advantageous, the early termination fees could offset these savings.
Therefore, if you are contemplating purchasing your leased vehicle before the end of the term, it's strongly recommended that you contact the leasing company or financial institution to fully understand any potential early termination fees or penalties. By doing so, you'll be in a position to make a more informed decision that takes into account all the financial implications involved.
Conclusion
Understanding how your monthly lease payments are calculated can give you a significant advantage when negotiating your car lease. While the Constant Yield Method may sound complex, it essentially boils down to understanding depreciation, interest, and the money factor. Remember, the more informed you are, the better decisions you can make.
Knowledge is power, especially when it comes to car leasing. Always read and understand your lease agreement before signing, and don't hesitate to ask questions of your dealer or the financial institution that is providing the lease, if there's anything you're unsure about.
If you're weighing the options of leasing or buying a car, CarOracle's Auto Loan Program offers expert assistance to guide you through your choices. Whether you're looking for a lease with favorable terms or exploring auto loan options, our program can help you make the best decision for your needs. Learn more about our Auto Loan Program.