That MF! No, Not THAT MF!
Have you ever wondered how an auto lease is calculated?
To calculate the finance charge for a lease, the following formula is used:
Finance charge = (Net cap cost + Residual value) x Money factor
But, what is a Money Factor? A money factor is the portion of the monthly payments on a lease that are allocated to the financing cost of the lease. Think of it as the interest paid on a mortgage. The money factor is typically not quoted in an APR (annual percentage rate).
A few things to remember:
The net cap cost is the negotiated price of the car minus any type of down payment.
The residual value is the estimated value of the vehicle at the end of the lease.
The money factor represents the interest rate on the remaining balance.
To convert the money factor into an interest rate, the following formula is used:
(Money factor x 2400) / (1 - Residual value / Net cap cost)
So why 2,400 is used as the multiplier to convert the money factor into an interest rate? To understand this, first understand how interest is compounded. Compounding is the process by which interest is calculated and added to the principal balance. The more frequently interest is compounded, the more interest is earned on interest. In the case of a lease, interest is typically compounded monthly.
To get the equivalent interest rate, the monthly interest rate must be multiplied by the number of months in a year. There are 12 months in a year, so the monthly interest rate is multiplied by 12 to get the annual interest rate. To convert the money factor into a percentage, it must be multiplied by 100. This gives us the formula:
(Money factor x 12) x 100= Equivalent interest rate
This formula would provide you with the correct annual interest rate if the interest rate were compounded annually, but interest on a car lease is compounded monthly, which means that interest is being charged on interest. To account for this, you would adjust the formula to include the number of compounding periods per year.
There are 12 months in a year, and interest is compounded monthly. Therefore, the number of compounding periods per year is 12. You can adjust the formula to get:
(Money factor x 12 x 100) / 12 = Equivalent interest rate
Simplifying this formula gives you:
Money factor x 1200 = Equivalent interest rate
However, you still need to convert the annual interest rate to a monthly rate to calculate the finance charge correctly. To do this, you divide the annual interest rate by 12:
Equivalent interest rate / 12 = Monthly interest rate
Finally, to calculate the finance charge, you multiply the monthly interest rate by the remaining balance.
Seems complicated right? Luckily most dealers have a "cheat sheet" on hand to show you are help you calculate your projected payments and interest. You don't have to be a mathematics guru to understand the difference in pricing - you are now an expert!