Companies will often enter into a lease agreement to purchase equipment, whether it's because they cannot afford to purchase it, or because they choose to lease for other business reasons. Instead of purchasing the equipment with a loan, the lease agreement allows the company to make monthly payments to acquire and use the equipment, while the leasing company still maintains ownership. The ratio between the monthly lease payment and the cost of the equipment is known as the lease rate factor_._
Leasing companies define equipment value as the monetary value the leaseholder – or lessee – receives from the equipment during the lease term. The equipment value is calculated as the difference between the retail price of the new equipment and the residual value of that equipment at the end of the lease term. For instance, Generic Storage Inc., leases a forklift valued at $50,000 for five years. The residual value of that forklift after five years is estimated at $14,000. The equipment value that Generic receives for that forklift over those five years is ($50,000-$14,000), or $36,000.
Lease payments have two components: depreciation and interest. The depreciation portion covers the depreciation cost of the equipment over the lease term. The equipment value the company receives for the equipment over the lease term represents the depreciation cost. In the case of the Generic example, the equipment value of the forklift is $36,000 and the lease term is five years, or 60 monthly payments. The depreciation portion of the monthly lease payment would be ($36,000/60), or $600.
The interest rate portion of the monthly lease payment relies on the lease rate factor. The lease rate factor is the annual interest rate divided by the number of monthly payments. If the current interest rate is 6 percent, then the lease rate factor in our example is (0.06/60), or 0.0010.
The interest portion of the monthly lease payment is the sum of the retail value and the residual value, multiplied by the lease rate factor. In this case, the interest payment is ($50,000+$14,000) * 0.0010, or $64. The total pre-tax monthly lease payment would be $600 for the depreciation, plus $64 for the interest, or $664.
Some lessees may confuse lease rate factors and interest rates. Although the two concepts are related, they are not identical. Interest rates can fluctuate as central banks decide to print more or less money. The lease rate factor in a leasing agreement stays the same throughout the lease term.
Also, most loan agreements require that the interest rate be printed in the contract. By contrast, many lease agreements do not include the lease rate factor in the contract, but they do include all the numbers needed to calculate it.