Leasing is based on the concept that you pay for the portion of the vehicle that you are using. This portion is most commonly referred to as the vehicle's depreciation. Depreciation is the difference between a vehicle's original value and its value at lease-end (residual value), and is the primary factor that determines the cost of leasing.

For example, if you consider two different cars; both costing $20,000 at time of purchase, where one is worth $15,000 after two years and the other worth only $12,000, the first car will cost less to lease because the difference between the selling price and 'residual value' is smaller.

Let's take a look at MSRP and residual value, as well as the other components of leasing - capitalized cost reduction, money factor and lease term - to understand how leasing works.

Manufacturer's Suggested Retail Price - MSRP

MSRP is the full price for a vehicle as displayed on its window sticker, including optional packages. Dealers will usually agree to discount the sticker price if you ask - and you are willing to haggle for it - unless the vehicle is in hot demand and low supply.

Capitalized Cost

When you and your dealer sit down and agree on a price for a leased car, this becomes the capitalized cost, or "cap cost." In a good lease deal, the cap cost will be significantly less than MSRP. Cap cost is sometimes called lease price or selling price.

Capitalized Cost Reduction

Capitalized cost (lease price) can be reduced by rebates, factory-to-dealer incentives, trade-in credit, or a cash down payment. These are known as cap cost reductions. Even modest cap cost reductions, such as a down payment, can create significantly smaller monthly lease payments, especially in shorter leases.

Residual Value

The wholesale value of a car at the end of its lease term, after it has depreciated, is called its residual value. The higher the residual value, the more the car is worth at lease-end - and the lower your lease payments.

Since nobody can truly predict the future, residuals are only educated guesses based on historical resale-value data for specific automobile makes and models. Leasing companies subscribe to services that provide this kind of industry data, and then use it to set their own residual numbers. Car manufacturers' leasing companies often temporarily boost residuals on slow selling vehicles so that they can offer better lease deals. These are called subvented deals.

Residuals are usually stated as a percentage of MSRP. A 36-month, 50% residual on a new $20,000 car means that its estimated depreciated value at the end of a 3 year lease will be $10,000. The actual value at the end of 36 months might be higher or lower.

Residual percentages decrease as the length of a lease, called the lease term, increases. This is because the older a vehicle gets, the less it's worth. For example, the 24-month residual on a particular car might be 57%, decreasing to 50% for 36 months, then to 44% for 48 months, and 39% for 60 months.

Residuals fall rapidly in the first 24 months, then more slowly in later months. This is why shorter term leases are more expensive than longer leases.

A rule-of-thumb: The best cars to lease are those whose 24-month residuals are at least 50% of their original MSRP value. Remember, the higher the residual, the lower the lease payments. This is not to say that cars with lower residuals cannot be good lease deals, it's just that you get more car for your dollar with the high-residual models. Lease companies often artificially raise residual values for a time on particular vehicles to make leasing them more attractive.

Lease Term

Lease term is the length of time a car is leased, usually expressed in number of months. Typical leases are 24, 36, or 48 months, although "oddball" terms, such as 30, 39, and 42 months are frequently seen in lease promotional ads.