Two people signed 36-month leases in 2023. One leased a Honda Civic, the other a Jeep Wrangler 4xe. Both are turning the cars in right now, and both have the option to buy instead. For the Civic driver, buying is worth about $5,500. For the Wrangler driver, buying would mean paying roughly $9,700 more than the vehicle is worth. Neither of them chose this outcome. It was decided for them in 2023, by a single number written into their contracts before either car left the lot.
That number is the residual value, and once you know how car leasing works you realize it has been handed two jobs that pull against each other.
A lease charges you for the drop, not the car
Start with what you are actually buying. When you take out a car loan, you are financing the whole vehicle and you own it at the end. When you lease, you are financing only the portion of the car’s value that disappears while you have it. The lender buys the car, hands it to you for three years, takes it back, and sells it. Your payments cover the difference between what it was worth at the start and what it is worth at the end, plus a financing charge for fronting the money.
So the arithmetic is simpler than it looks. Take a $40,000 car with a residual value set at 60%, which is $24,000, on a 36-month lease. The value expected to vanish is $16,000. Spread across 36 months, that is $444.44 a month in depreciation. That is the bulk of your payment, and it is why an expensive car that holds its value can lease for less than a cheaper car that does not.
That structure used to make leasing the obviously cheaper monthly option. It barely does anymore. Experian put the average monthly lease payment at $659 in 2025, just $23 below the average auto loan payment of $682. In 2022 the gap was $55, and Experian’s explanation for the narrowing is worth holding onto: the rate spike of that year hit buyers harder than lessees at first, because a lessee only finances the depreciation, and then rising vehicle prices caught up with lessees too. Both halves of the lease formula got more expensive.
How car leasing works once you convert the money factor
The second piece of your payment is the financing charge, and the industry has a peculiar way of quoting it. Instead of an interest rate, you get a money factor: a decimal like 0.00250 that looks like a typo. Multiply it by 2,400 and you have the equivalent annual rate. A money factor of 0.00250 is 6% APR.
The charge itself is calculated on the sum of what the car costs and what it will be worth at the end, not on a declining balance. On our $40,000 car with a $24,000 residual, that is $64,000 multiplied by 0.00250, or $160 a month. Add the $444.44 of depreciation and the base payment is $604.44 before tax and fees.
Now watch what one decimal place does. Move the money factor from 0.00250 to 0.00375 and you have gone from 6% to 9%. The monthly charge goes from $160 to $240. That is $80 a month, or $2,880 across the lease, hiding behind a number most people never look at twice.
Federal law does require the dealer to hand you the components. Regulation M, which implements the Consumer Leasing Act at 12 CFR Part 1013, applies to any consumer lease with an initial term longer than four months and requires uniform cost disclosures: the gross capitalized cost, the residual value, the depreciation amount, and the total rent charge in dollars. What Regulation M does not require is an annual percentage rate. Auto loans get one, because Regulation Z mandates it. Leases do not. The rent charge is disclosed as a lump sum of dollars, and converting it into a rate you can compare against a loan is left entirely to you. That is not a loophole anyone is hiding. It is just an asymmetry in the rules, and it is the reason the money factor survives as a quoting convention at all.
The residual is a forecast, and someone else makes it
The residual value is not an appraisal. It is a prediction, made by the captive finance company (Honda Financial Services, Chrysler Capital, and so on) about what a car will be worth three years from now, written down before anyone knows what the used market will do. Dealers do not set it. You certainly do not negotiate it.
And it does double duty. The same number that determines how much depreciation you pay for is also, in most contracts, your fixed purchase option price at the end. Those two roles point in opposite directions. A high residual means less depreciation to cover, so your monthly payment drops, which is exactly why manufacturers inflate residuals on models they want to move. But a high residual is also a high buyout price. You get the cheap payment now and an expensive option later. Set the residual low and the reverse happens: you pay more each month, and you end up holding an option to buy the car for less than it is worth.
Once you see it that way, the mileage cap stops looking arbitrary too. The residual was forecast for a car with a specific number of miles on it. Drive past that and you have damaged the asset the forecast was built on, so you pay per mile to make the lender whole.
2026 is showing what happens when the forecast misses
Forecasts miss, and this year the misses are unusually large in both directions.
Edmunds reported that three-year-old vehicles retained just 66% of their original MSRP on average in the first quarter of 2026, a five-year low. That is the aggregate picture: residuals have drifted back toward pre-pandemic norms after years of used-car prices running hot. Meanwhile three-year-old used vehicles still averaged $31,548 in Q1 2026, the second-highest first quarter on record, behind only the $32,164 peak of early 2022.
Averages hide the interesting part, though, because a 66% average is made of individual forecasts that were badly wrong in opposite directions. Edmunds put the 2023 Honda Civic’s original lease MSRP at $27,374 with an estimated resale value of $17,704. Its actual average transaction price in Q1 2026 was $23,249. The car beat its forecast by $5,545, so buying it out at the contract price is straightforwardly a good deal. The Jeep Wrangler 4xe went the other way: $64,112 original MSRP, $39,167 estimated resale, and an actual Q1 2026 price of $29,505. That is $9,662 below the buyout price. Returning it is the obvious move, and the finance company eats the difference.
That asymmetry is not random. Plug-in hybrids and EVs leased heavily in 2023 because the Inflation Reduction Act’s $7,500 credit could be passed through on a lease without the income and manufacturing limits that applied to purchases. Edmunds found they made up 12.4% of dealership leases that year. Residuals were set on those cars at the peak of enthusiasm, and the used market has repriced them hard since. All that inventory is landing now, with off-lease volumes projected to rise 25.7% in 2026.
Notice who absorbed the loss. The lender did, because you held an option rather than an obligation. That protection is genuinely the thing a lease sells you, and it is worth something in a market like this one. It is also why lease penetration has fallen to about 20% of new-vehicle transactions from a peak near 29% in 2018 and 2019. Lenders got burned by their own forecasts and priced leases accordingly.
The two numbers to write down before you sign
Both of the numbers that matter are already printed in the paperwork, and neither is the monthly payment. Find the residual value and divide it by the MSRP. A percentage well above what similar cars have historically held tells you your payment is being subsidized by an optimistic forecast, and that your purchase option will probably be worth skipping. A conservative percentage means the reverse. Then find the money factor, multiply it by 2,400, and compare that rate to what your bank or credit union would quote you on a loan for the same vehicle. The difference between those two rates is the price of the walk-away right, quoted in a unit you can finally read.
Strip away the vocabulary and how car leasing works is just a forecast plus a financing charge quoted in the wrong units. Running those two calculations at signing will not let you control what the used-car market does three years later. The Civic and the Wrangler drivers had no say in that. What it will tell you is which of those two outcomes your contract was already leaning toward on the day you signed it, and whether the payment you were quoted was cheap for a good reason or an optimistic one. If you are weighing a lease against financing, our explainer on how car loan financing works covers the other side of that comparison, and what gap insurance actually covers is worth reading before you sign either one.