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. Your lease payments may either stay the same, increase, or decrease throughout the lease term. Factors affecting the payment include:
the lease lengththe asset’s expected residual value (its starting value minus depreciation over the lease term)lease or money factor (similar to interest)applicable taxesdown payments made to reduce the asset’s capitalized costmaintenance 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.
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.
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.
