Automobile leasing is based entirely on the concept that you pay for the amount by which a vehicle's value depreciates during the time you're driving it. Depreciation is the difference between a vehicle's original value (MSRP) and it's value at lease-end (residual value), and is the primary factor that determines the cost of leasing.

Different makes and models of vehicles can have dramatically different depreciation rates. Those vehicles having the lowest depreciation make the best lease deals.

If you consider two different cars, both costing $20,000 when new, 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 of it's smaller depreciation amount.

Open-Let's take a look at MSRP and residual value, as well as the other components of leasing capitalized cost reduction, money factor and 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. Destination charges and dealer add-on items are not considered part of MSRP, although these charges are part of the overall cost of the vehicle.

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.

Because this is where dealers make their profit, they will sometimes imply, or possibly state outright, that price isn't negotiable in a lease, that somehow leases are different because you aren't buying the car. This is simply not true. It's in your best interest to negotiate the lowest capitalized cost possible a discount off the sticker price just as if you were buying. The lower your cap cost, the lower your monthly lease payments will be.

Capitalized cost may also include certain fees, such as an acquisition fee (similar to mortgage "points" , or loan origination fee). If you haven't fully paid off the vehicle you're trading, cap cost would also include your remaining loan balance (this is not a good practice if you can avoid it).

Capitalized Cost Reduction

Capitalized cost (lease price) can be reduced by customer rebates, factory-to-dealer incentives, trade-ins, or a 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.

When you subtract cap cost reductions from cap cost, you get net capitalized cost, sometimes called adjusted cap cost.

The worth 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.

Residual percentages decrease as the length of a lease, called the 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.

A rule-of-thumb: The best cars to lease are those whose 48-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. Generally, the vehicles currently sporting the highest residuals are SUVs, non-American luxury cars, and certain truck models.

When you lease, you're tying up the leasing company's money while you're driving their car. They rightfully expect you to pay interest on that money, the same as with a purchase loan.

This interest is called money factor, sometimes called lease factor, which is expressed as a small decimal number such as .00297. (Note: dealers will sometimes confuse you by quoting money factor as a larger decimal, such as 2.97, which means .00297, because it sounds like an attractive annual interest rate.) Money factors can be converted to annual interest rate by multiplying by 24 (yes, it is always 24 and not related to the length of the loan in months). For example, a money factor of .00297 multiplied by 24 = .0713 = 7.13%.

A good rule of thumb: Money factor should at least be comparable to, if not lower than local new-car loan interest rates. Like interest on a loan, the lower the money factor, the lower your monthly payments.

Some recent manufacturers' lease deals have offered money factors as low as .000625 (1.5% APR), or lower. However, you may not qualify for the great money factors unless if you have a spotless, or near spotless, credit rating. Otherwise, you'll pay at a higher rate or not be able to get the deal at all if your credit is really terrible.

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.

Although longer leases produce somewhat lower monthly payments, it may be smarter to match your lease term to the length of the vehicle manufacturer's warranty. In other words, don't lease for any longer than the warranty that comes with the vehicle — and don't buy an extended warranty. That way, you're covered for the entire duration of the lease if something breaks. For this reason, 60 month leases, which are declining in popularity, are not recommended.