What is Lease Rate Factor?
The lease rate factor is defined as the regular payment which one needs to make when an asset is taken under the lease agreement and is usually expressed as a percentage of the total price of the equipment which has been leased. Alternatively, it can be defined as the single rate factor which when multiplied by the cost of the leased equipment will give the regular stream of payment which one has to do for taking the lease.
Suppose an equipment of cost $10,000 has a lease rate factor of .0260, it means a monthly payment of (10,000 *.0260) = $260. This means that the lessee must make every month payment of $260 for leasing the equipment in consideration for the required number of periods, which is set in the leaseLeaseLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.” agreement.
There are primarily two types, which are generally explained as car/equipment lease and space lease rate factor. In-car and equipment leasing the company which leases out the objects primarily purchases the car or equipment from third-party dealers or agents and provides us the same on rent. It means that we are paying for the loan which the lessorThe Loan Which The LessorA lessor is an individual who legally owns the asset granted on a lease (rented for a long tenure) to the lessee who pays a single lump sum amount or regular payments for using that asset. has borne to purchase the item by lending money upfront to buy the car/equipment.
- At times both the car provider and lessor can be the single entity where a third-party contract provides the car provider to sell stock to the lessor. Further, this is used to produce revenue on these assets/objects before transferring back the car/equipment back to its provider as used items. The lesseeThe LesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. , on the other hand, gets the object which can be used even without being the owner or bearing the pressure of owning it.
- When it comes to real estate, the prime purpose of it is to generate rental income from the tenants. Thus, only two parties get involved in this mode of execution, and any reimbursement for the application of funds into the real estate is covered up in the rate of leasing as the strategy of the entire business setup.
How it’s Calculate?
- The first and foremost thing taken into consideration is the equipment value and the depreciation rateDepreciation RateThe depreciation rate is the percent rate at which an asset depreciates during its estimated useful life. It can also be defined as the percentage of a company's long-term investment in an asset that the firm claims as a tax-deductible expense throughout the asset's useful life. before we calculate the lease rate factor. The calculation of the equipment value also has a methodology associated with it. Suppose we are leasing equipmentLeasing EquipmentEquipment Lease is where the equipment owner allows another party to use it in exchange of periodic rentals with no transfer of ownership and has the right to cancel the lease right away in case of breach of the lease agreement. whose retail price if we purchase new is $70,000 and has a useful lifeA Useful LifeUseful life is the estimated time period for which the asset is expected to be functional and can be put to use for the company’s core operations. It serves as an important input for calculating depreciation for assets which affects the profitability and carrying value of the assets. of 10 years. That means after 10 years after applying depreciation over it, the residual value stands to be $10,000. Then the equipment value for leasing stands to be $70,000- $10,000 = $60,000.
- Now coming to the calculation of depreciation part, here we have seen the equipment value on the grounds of leasing stands to be $60,000 and suppose the lease term has been set to 5 years. Thus, the depreciation part of the lease paymentLease PaymentLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration. to be made monthly will stand as $60,000/60 = $1,000.
- Coming to this calculation, let us, for example, consider the annual rate of interest to be as 5% per annum. It is calculated basically by dividing the interest rate with the number of months considered for leasing. So here it will be (0.05/60) = 0.008.
- So finally, to arrive at the monthly amount to be paid for the lease, we need first to calculate the interest payment, which is calculated as follows: ($70,000+$10,000) *0.008 = $640. The total payment which must be made includes the depreciation part too, and thus it makes $1,000+$640 = $1,640.
Let us take an example of a piece of machinery used to produce toys that have been leased for 5 years with a lease rate factor of 0.008. It means considering the annual rate of interest in the market as 5%; the factor has been calculated by dividing the interest rateInterest RateAn interest rate formula is used to calculate loan repayment amounts as well as interest earned on fixed deposits, mutual funds, and other investments. It is also used to calculate credit card interest. with the number of years the lease is concerned. i.e. 0.05/60 = 0.008. For calculating the interest payment, the market value of the equipment plus the residual valueResidual ValueResidual value is the estimated scrap value of an asset at the end of its lease or useful life, also known as the salvage value. It represents the amount of value the owner will obtain or expect to get eventually when the asset is disposed. is added and multiplied with the lease factor.
Lease Rate Factor Conversion to Interest Rate
The consideration of both interest rate and the lease factor is very important when we want to check which is costing us less, i.e., whether going into a lease agreement is beneficial to buying equipment where interest payment on loans comes into the picture. A very important number that comes into this comparison is 2400, which gets multiplied to the lease rate factor to arrive at the interest rate. An example of this can suppose we have a lease rate factor of 0.003 as mentioned above when we want to convert it to the interest rate; we simply multiply the factor with 2400, i.e., 0.003*2400 = 7.2%. Thus, we see here the annual interest rate comes to be 7.2% when the leasing factor is used in 0.003. To cross verify this calculation we can again do a reverse calculation, i.e., 7.2/2400 = 0.003
Why Are They Used?
- There is a constant on-going debate about when to lease space/equipment and when to own the entire thing. The main factor which plays importance in leasing is the concept of time and time value of money. In simple words, we need to consider how long we are going to use the leased property.
- To minimize the residual/sunk cost when the demand for certain equipment is only meant for a short-term basis, leasing is the ideal decision. These can be cases of operational requirements needed for expansion or growth coupled with temporary market conditions. At this point, leasing is an idle scenario because it reduces the burden of owning the equipment as a whole and thus ending up with a huge sunk costSunk CostSunk costs are all costs incurred by the firm in the past with no hope of recovery in the future and are not considered while making any decisions since these costs will not change regardless of the decision's outcome. at the end.
- Also, when a company does not want to focus on non-core business issues like equipment and property maintenance, leasing can be an option as it removes the burden of owning the same and again maintaining it too.
Lease Rate Factor vs. Interest Rate
The lease rate factor has a money factor instead of an interest rate, whereas an interest rate factor has a percentage rate of interest, which is calculated annually. At any time when we want to convert the money factor or lease rate factor to interest rate, we need to multiply the same with 2400. Lease factors can, at times, make very costly loans look cheaper. Here, the user of the asset needs not to hold the asset with him/her till it reaches its residual value, thus cost savings in this way can be brought in. The loan agreement where interest rate comes into picture the owner of the asset must bear both the charges of the loan and interest and also the residual value of the asset.
It is very important to understand and estimate the overall payment, which needs to be made for the purpose of the lease, or else the lessor can easily add few extra amounts, and the lessee will not even come to know about it. A small extra amount added every month unknowingly can turn out to be a big number at the end of the lease period. It helps us to understand the overall cost of leasing. The interest rate may change depending on the market scenarios, but the lease rate factor once entered into an agreement remains fixed for the rest of the term of the lease.
This article has been a guide to What is Lease Rate Factor & its Definition. Here we discuss how to calculate the lease rate factor and types along with examples and why it’s used. You can learn more about from the following articles –