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Let me preface: I have learned my lesson and am trying to mitigate the consequences as much as possible. I was naive and did not fully understand what I was agreeing to.

I was talked into trading in my paid off vehicle to lease a brand new car. The trade-in value they gave me for my vehicle was $14,000** and the lease amount is about $3,000 (won me over with the $80 payments). So by the end of the lease, I should have around $17,000 invested into the car.

With that in mind, I intend on purchasing the car and re-selling it.

Residual Value: $16,000
Current Estimated Value: $20,000

Now my question is, does my current equity in the car count towards the residual value? (i.e. at the end of the lease I will have essentially paid it off***?)

Or, is that the remaining balance after my equity has been applied so I will need an auto loan for that amount? (i.e. end up paying over $30,000 for the car)

My lease ends in a year and I am considering buying out of it early (scared about losing all equity if it gets totaled).

**Probably my biggest mistake was not even looking to see what they were offering for my car and negotiating that price (or realize I was being taken advantage of). They could tell I did not understand what was happening as I was not asking the questions that should be asked. What else could you expect from a car salesman?

***that'd be too good to be true

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If you are leasing, then you have zero equity. Leasing is another word for renting. Renters do not build equity because they have no ownership interest in whatever item they are renting.

The lease on a vehicle is typically calculated as the current value minus the estimated value at the end of the lease period (plus any applicable finance charges and some variable fees). At the end of that time, the dealer is betting that the car can be sold for at least as much as the estimated value.

If the dealer took your trade-in at $14,000 and gave you a lease on a new vehicle for $3,000 additional, that means that the difference between the original value of the vehicle and the value at the end of the lease period should be about $17,000, which is the total amount you would pay. At the end of that time, the vehicle may be worth anywhere between $0 and $1,000,000,000 (hyperbole for effect) but no matter what it is, you don't get any of it.

Most lease agreements will specify a "buy-out" amount that you can pay to purchase the vehicle at the end of the term, which should be the estimated value from above. Your hope is that the buy-out cost is lower than the actual value. Your buy-out amount at some point prior to the end of the lease would be that amount plus any amount you still owe on the lease (since that amount is needed to cover the full price of the vehicle).

Based on your figures, it seems likely that the original value of the car was around $32,000, and you would pay around $14,000 (up-front) + $3,000 (over 3 years), at which time you either pay an additional $16,000 (the estimated value of the car after 3 years - depreciation of roughly half, which is reasonable) to buy it outright, or return it and owe nothing further. Right now, with a year left in your lease, you owe around $1,000 on the lease. If you wish to own the car, you must come up with that $1,000 plus the $16,000 (and assume that your lease agreement lets you buy out early). The fact that the car is worth $20000 right now doesn't have any bearing. In that case, yes - you would end up paying $16,000+$14,000+$3,000, or $33,000, to buy a $32,000 car - or very nearly exactly what you would have paid if you'd bought it outright instead of being lured by an $80 lease payment.

You say you want to "protect your equity" if the vehicle were totaled in an accident. You should already be carrying collision and comprehensive insurance on your vehicle; I guarantee the lease agreement insists on this to protect their equity. If the car were totaled, your first obligation would be to pay the financing company for both the remainder of the lease, plus the buy-out value of the vehicle (which they could no longer sell since it's been totaled). You are unlikely to have anything left over from insurance but you might be lucky.

Leases on vehicles which hold their value well over time end up being relatively inexpensive - a Toyota Corolla bought for $20,000 can be had used for $13,000 after 3 years, depreciating only 35% - it isn't worth that much less than a brand-new one because people trust them. Conversely, leases on cars that do not hold value well can be very expensive because you are still paying for the car. A 7-series BMW with an original price of $115,000 is worth only $45,000 after 3 years, depreciating 61%. You can pick up off-lease luxury cars fairly inexpensively because of this. (Don't assume that everyone you see driving a Bentley is rich.)

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The residual value is what the financing company wants for the vehicle at the end of the lease, so you would have to give them $16k (regardless of any other payments made up until that point for leasing, repairs, etc) if you want to keep the car.

If you don't purchase the vehicle and instead turn it in, they will most likely sell it to one of their dealers, or (if it is in bad shape) send it to auction. In either of these cases they are not likely to get exactly what they predicted as the residual value. There are a lot of factors that go into estimating what a vehicle will be worth 3, 4, 5 years from now, so they often get it wrong. It will sometimes be worth a little more, sometimes less. Dealers won't want to pay book value for it anyway because they need room to add their margin.

All of this is to say that only you can decide if the residual value is a good deal for you when you reach the end of your lease. If you have put minimal miles on the vehicle and the car is in great shape then the residual may be less than what it would cost to buy a similar used car (make, model, mileage, condition) at market rates on the day your lease ends. Alternately, if the finance company did a poor job of estimating its future value, then the residual may seem over-priced compared to similar cars available at the time.

In some cases (E.g. there is a bunch of damage needing to be repaired, or at least paid for before they will take it back) it may still be better value to pay the inflated residual value in order to get out of having to pay for repairs and/or excess mileage, because they will typically charge more for those items than the extent to which the damage/mileage will have actually diminished the vehicle's resale value, thus adding to your overall sunk costs if you were to turn it in.

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This is not an investment. You have invested $0 in to anything. You didn't invest in a car you paid for a car. IF the car has a market value above your remaining loan balance or the remaining lease payments + the residual buy out amount + any exit fee, then you can sell the car repay the lender and pocket the remaining money.

Now in detail, buying versus leasing in the US.

When you buy a car, considering a $20,000 car, you give the owner of that car $20,000 and it's yours. If a lender lends you the money to buy the car, then the owner of the car gets $20,000, you get the car, the lender takes a lien on the car to give the lender some rights to take possession of the car and or be paid first in the event you sell it.

In the US a lease is essentially a loan with a big optional balloon payment. In this situation you sit down with the owner of the car and come to an agreement that you probably only want the car for three years, and in three years the car will probably depreciate by 40%. So you effectively get a loan where your payment terms repay just the 40% depreciation plus interest on the whole value of the car and you have an option to buy at the end of the term for the remaining 60%. Titling of the car is a little different, and there can be some imposed terms and costs related to exiting the agreement.

When leasing you are agreeing that this is the price of the car now, AND this is the price of the car in the future. In order to sell the car in the future, the lessor will want all of the remaining lease payments and generally a fee, because you agreed to the value and a set depreciation table.

No matter how the car is paid for the loan on the car and the value of the car change over time. In the overwhelming majority of cases the car loses value over the life of your ownership, but in the case of some more rare cars the value could increase. Alternative you might simply owe less than the market value for the car. But, in any situation the car has value X the remaining amount due on the loan (or lease agreement) is value Y, if X - Y is a positive number you have "equity." Obviously if you own the car outright Y is zero.


Leases get a terrible rap in financial communities. "It's just a rental." But There are cases such as high sales tax states, especially those with no trade-in offset like CA, where IF you were going to go get some car and hold it temporarily, leasing can work out in your favor as sales tax is applied to the lease payment rather than the value of the car. Taking some $100,000 sports car (it's not difficult to hit that price any more) You're talking about ~$9,000 in sales tax on day one in California versus about $100 per month added to your lease payment. You save about $5,400 in sales tax (which might be eaten up by gap insurance and interest) and you get a captive buyer to take the car back after 36 months.

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