I recently helped my fiancée decide between leasing and purchasing a new car. When I could not find a model helping evaluate the relative economic attractiveness of a lease, I built one. You can download it here. Below, is an explanation of the logic driving the model. If you have any questions or feedback, please let me know.

THE MODEL

The model is pretty straightforward, and allows you to compare one loan to one lease at a time. The model will tell you if the lease or the loan is economically better, and by how much.

LOGIC BEHIND THE MODEL

Evaluating the economic attractiveness of a car loan versus lease essentially requires calculating the “equity”–whether realizable (in the case of loan) or not (in the case of lease)–you as the leasor would have in the vehicle when the would-be lease ends. The vehicle’s value at some future point in time doesn’t depend on your lease / buy decision. Thus, the only question is what the vehicle’s value will be (vehicle purchase price less depreciation) and how much you will have paid through that forward moment in time (sum of your payments).

Determining the economic attractiveness of a car loan is easier because it is as simple as calculating the equity you would have in the vehicle. Evaluating economic attractiveness of a lease was slightly trickier to figure out because you don’t actually own the car when the lease terminates.

The way I thought about how to evaluate a lease is to look at the lease from the leasor’s perspective. If the lease is good for the leasor, it is bad for you. Conversely, if it is good for you, it is bad for the leasor. So we want to look for the scenario wherein it is bad for the leasor. A lease is a bad deal for the leasor if the leasee doesn’t pay for all of the vehicle’s depreciation upon return of the vehicle. In such a case the vehicle will have lost $X dollars of value (due to depreciation) and the leasor will have received less than $X dollars of payments from the leasee. Hence, a lease is good deal for the leasee if the sum of your payments is less than the vehicle’s lost value. In such a case, the leasor is essentially paying for some of the vehicle’s depreciation, instead of you.

If this is still not clear, consider the following. The ideal lease for a leasor is one in which the leasee’s total payments exceed the total depreciation of the vehicle, such that the leasor can then sell the vehicle at market value for a profit. When selling the vehicle, we can safely assume that leasor will not be able to sell it for more than it’s expected market value (purchase price less depreciation), which acts as the max expected sales price. Now, since the leasee paid the leasor X dollars of payments, and the vehicle depreciated by W from Z and is now worth Y, to sell a vehicle at a profit, the leasor must sell the vehicle for at least Y-(X-W).  As you can see from this equation, the more money the leasee pays (ie. the larger X gets), the lower the minimum profitable sales price becomes, thus increasing the likely profit that the leasor will make upon selling of the vehicle.