What Are Lease Payments?

A businessperson leases a building. — Photo:
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Definition

Lease payments are monthly fees paid for the right to use an asset under the terms of a contract between the lessor who owns it and the lessee who will use it. Lease payments usually continue for a designated time period before the lessee either returns the asset or buys it out.

Key Takeaways

Lease payments work like rental fees you pay for the right to use the owner’s asset under specified terms.
The lease payment amount includes costs for monthly depreciation, finance charges, and applicable taxes.
Depending on the situation, you might return the asset after the final lease payment or buy it.
Operating and capital lease payments reflect differently on a business’s financial statements.

How Lease Payments Work

If you or your small business need an asset but you don’t want to purchase it, you could enter a lease agreement with the asset’s owner. Instead of buying, you can lease physical assets such as buildings and equipment, or intangible assets such as patents and software licenses.

You and the lessor sign a lease agreement specifying terms such as the included rights and obligations, lease term length, lease payment amount, late fees, procedures, and options at lease expiration.

Note

Once the agreement is in place, your monthly lease payment gives you the right to use the lessor’s asset per the terms of the agreement. The payment amount is usually calculated based in part on the monthly depreciation and finance charges plus any taxes that may be included.

Your lease payments may either stay the same, increase, or decrease throughout the lease term. Factors affecting the payment include:

the lease length
the asset’s expected residual value (its starting value minus depreciation over the lease term)
lease or money factor (similar to interest)
applicable taxes
down payments made to reduce the asset’s capitalized cost
maintenance costs

Certain factors can make your lease payments higher or lower. For example, having a good credit history or choosing an asset with a significant residual value can result in a lower finance charge. On the other hand, a variable rate or lease-by-the-hour agreement can make the payment lower or higher depending on how rate or hourly use changes occur.

You’ll pay lower payments with a longer lease term compared to a shorter lease term, although you may pay more overall. However, entering a lease agreement with a low-cost purchase option would result in higher monthly lease payments.

You’ll make your agreed-upon lease payments either until the term ends or if you terminate the lease early, which may or may not result in penalty fees. Missing a payment can lead to late fees or even repossession of the leased asset. You’re also responsible for following the lease terms about the use of the asset and paying for any damage that occurs.

Note

After making the last lease payment, you’ll likely pay any final fees due and return the asset, unless you have a buyout agreement or option. Other options could include extending the lease or taking out a new one.

Example of Lease Payments

Let’s say you own a small pizza restaurant and want to begin a delivery service. You decide to lease a commercial vehicle from a local dealership. You choose a close-ended lease that allows you to drive 15,000 miles annually before overage fees apply. You return the car at the end of a 24-month term.

The dealership calculates your monthly lease payments using several steps:

Your vehicle’s residual value is multiplied by the manufacturer’s suggested retail price by the determined residual percentage.
Your monthly depreciation amount is calculated by subtracting the delivery vehicle’s expected residual value from its adjusted capitalized cost, then dividing the result by the number of months in the lease term.
Your monthly finance charge is the vehicle’s capitalized cost plus residual value times the offered money factor. Your credit score, the vehicle, and specific lease terms all affect the money factor.
Your monthly finance charge plus monthly depreciation determines the base lease payment.
Your base lease payment plus any state taxes that apply get rolled into the lease.

To initiate the lease, you pay upfront costs including applicable fees and taxes, the first lease payment, and any required security deposit and down payment. You then make the agreed monthly lease payments on time, and account for the payments properly on your business’s financial statements and tax returns.

At the end of the 24-month term, you decide to return the delivery vehicle to the dealership and pay any fees for excessive mileage or wear-and-tear due.

Types of Lease Payments

There are two main types of lease arrangements: capital and operating. Which one you choose affects both the amount of the lease payments and what happens to the asset at the end of the lease term.

Note

If you’re a small business owner, ensure your lease is classified appropriately to avoid issues with misrepresentation on your business’s financial statements.

Operating Leases

An operating lease is a standard rental agreement in which your business treats the lease payments as operational expenses and eventually returns the asset to the lessor.

With an operating lease, you don’t list the asset on your balance sheet unless the lease term extends past one year. Instead, it is listed on a business’s income statement.

An operating lease is considered a less risky option for lessees since the lessor takes on most of the risk.

Capital Leases

A capital lease—or finance lease—would involve your small business ultimately gaining ownership of the asset. You list the leased asset on the balance sheet and treat the lease payments as a reduction to the lease obligation liability. You can deduct the leased asset’s interest and depreciation expenses on your small business taxes.

You accept all the responsibilities and risks with this arrangement. The total lease payments and residual value paid at the lease term expiration should match the asset’s fair value.

Frequently Asked Questions (FAQs)

What is the formula for lease payments?

A simplified lease payment formula, such as for a business car or farm equipment, is the monthly depreciation fee plus the monthly finance fee plus any applicable taxes. The depreciation fee would be the difference between the net asset cost (accounting for certain fees and reductions such as rebates and down payments) and residual value divided by the number of months of the lease term. The finance fee would be the net cost plus residual value times the determined money factor. Taxes are charged on both the finance fee and depreciation.

What is a lease payment example?

An example of a lease payment is a scenario in which you need a $100,000 piece of equipment for your small business and you would like to eventually own it. Therefore, you decide on a capital lease that lets you purchase the equipment for $1 upon term expiration. You agree to a 60-month term with a lease interest rate of 6.95% based on a money factor of 0.01978. The lessor calculates that you’ll have an estimated monthly lease payment of $1,978 plus any taxes. You also make a down payment equal to the first and last months of payments.

Is leasing worth it?

Leasing can be worth it if your small business lacks the money to purchase the asset or needs the asset only for a specified time. You can also benefit from fewer hassles if you get included maintenance, and you could get tax deductions. However, carefully weigh the costs of leasing versus buying, and understand that an early termination fee usually applies if you need out early. In addition, you’ll need to decide whether an operating or capital lease better suits your situation.

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Sources

The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.

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Harvard Business School. “What Is Lease Accounting & Why Is It Important?”
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