What Is Residual Value?

DEFINITION

Residual value is the expected value of a car at the end of the lease term.

Definition and Examples of Residual Value

Residual value is the estimated value a vehicle will retain at the end of the lease period. It's one of the most important determining factors in the cost of a car lease, both to you and the lender.

• Alternate name: residual lease value

For example, suppose you've leased a car and are turning it in. The leasing company sets the residual value of your car at 50%. If it has a manufacturer-suggested retail price (MSRP) of \$38,000, your car's residual value is \$19,000.

How Does Residual Value Work?

The residual value is projected by the lending institution holding the lease contract. They may reference several industry resources, but every lender calculates residual value differently.

The lender will use the residual value as one of the main determining factors when calculating your monthly lease payment. They'll do the calculation as follows:

1. You and the lender decide on the vehicle cost, less any trade-in value or down payment.
2. The lender obtains your desired lease term and determines its residual value based on the agreed-upon cost at the end of that term.
3. They determine the vehicle's depreciation—the starting cost minus the residual value.
4. They add the depreciation amount to any rent charges, taxes, and fees, and divide that amount by the number of months in the lease term to calculate your monthly payment.

So, if you're leasing a \$30,000 vehicle that is expected to depreciate by 20% over a one-year lease term, the car's residual value at the end of the lease period would be \$24,000. You'll pay \$6,000 for the vehicle’s depreciation (\$30,000 minus the residual value). That amount plus rent charges, taxes, and fees gets divided by 12 months, resulting in a \$500 monthly payment before taxes and fees.

If you're looking for a vehicle that will retain a high residual value to lower your monthly payments, Kelley Blue Book produces an annual Best Resale Value Award guide.

Ultimately, it will be the lender and not you who determines the residual value, but it’s a good idea to have a general sense of the vehicles with the highest and lowest residual values.

Residual Value Considerations

If you're looking to lease a vehicle for a set period and then move on with your life, looking for a car with a high residual value is a good idea. If a car retains more of its value, the depreciation amount and monthly payments will often be lower.

Residual Value Can Lower the Purchase Cost

If you plan to purchase the vehicle at the end of the lease term, one good choice is to find one with a lower-residual-value. While you'll pay more monthly during the lease term, the purchase cost at the end of the lease will be lower—the residual value plus any purchase-option fees.

Residual Value Can Be Used as a Comparative Tool

Keep in mind that discrepancies can occur between the residual value and market value at the time when you're ready to buy the car. This is because the lender may incorrectly estimate the car's value at the end of the lease term. A lease buyout is generally worthwhile when the residual value is lower than the market value. If the residual value is greater than the market value, you will pay more for the car than it is worth.

Be cautious about working with "lease-here-pay-here" dealerships. These dealerships lease used vehicles and may have weekly payments and no coverage for repairs, so review the terms carefully before proceeding.

It's also a good idea to compare the total cost of leasing and purchasing to buying the vehicle from the start. By comparing, you can choose the cheapest method and save some money.

Residual Value Isn't the Only Factor

Residual value isn't the only aspect to consider when leasing a car. The amount you must put down upfront, the interest rate, and the taxes and fees are other important considerations. If you have a poor credit score, your interest rate will likely be higher, and it's even more important to shop around for the best interest rate if you fall into this category. A high interest rate or high fees associated with a poor credit score can add a significant amount to your monthly payment and the total cost of leasing a vehicle.

Residual Value vs. Salvage Value

The term "residual value" is sometimes used interchangeably with "salvage value," but residual value is more commonly used in leasing to refer to the projected value of a car at the end of the lease term.

"Salvage value" is a more general accounting term regarded as the fair market value of an asset. You could also think of it as the value that would be recovered from the car's sale at the end of its useful life. In the context of vehicles, you can think of the salvage value as the amount collected if an insurance company were to sell the vehicle to a salvage yard for its parts.

The salvage value may be much lower than the residual value, depending on the car's condition at the end of the lease, which may be well before the end of the car's life. Moreover, whereas a lender would estimate the residual value based on the cost and lease term, an insurance adjuster will estimate the salvage value based on the cost of vehicle disposal and previous auction values for similar salvaged cars.

Key Takeaways

• Residual value is the expected value of a car at the end of the lease term.
• Lenders estimate the value based on the agreed-upon cost of the car and the desired lease term.
• It's one of the most critical factors for your monthly lease payment amount.
• Cars with high residual value are generally preferable when leasing as they're associated with lower monthly payments. When buying out a car lease, you want the residual value to be lower than the market value.
• Residual value differs slightly from salvage value, which is the value you'd get if an insurer wee to sell a car to a salvage yard at the end of its useful life.