What it means
When a business leases an asset, the lessor (the owner) recovers its cost, earns a return and covers risk through the lease rate. For equipment and vehicles, the payment has two parts: a charge for the fall in value of the asset over the lease, and a charge for the financing.
The lower the expected value of the asset at the end, called the residual value, the higher the depreciation charge. Auto and equipment lessors often quote a money factor or lease rate factor instead of an interest rate.
The money factor is a small decimal, and multiplying it by 2,400 gives an approximate annual percentage rate. A money factor of 0.0025 therefore equals an annual rate of about 6%.
In commercial property, the lease rate is the rent per unit of space, usually per square foot or square metre per year. It may be quoted as gross, where the landlord pays operating costs, or net, where the tenant pays some or all of them in addition.
Comparing offers fairly means converting them to the same basis. For a finance professional, the lease rate is the key input to a lease-versus-buy decision.
The lessee compares the total of lease payments with the cost of borrowing and buying, adjusting for tax, maintenance and flexibility. Under modern lease accounting, the present value of payments, discounted at the rate implicit in the lease or the lessee's borrowing rate, normally appears on the balance sheet.
A nuance is that a low monthly payment is not always a low lease rate. Longer terms, a higher assumed residual value or large upfront fees can reduce the payment while hiding a higher cost.
Always compare the total cost over the life of the lease and the effective annual rate.
In practice
Real-world examples.
Example
A courier firm leases ten delivery vans on 36-month terms. The lessor quotes a money factor of 0.0025 and a residual value for each van. The finance manager converts the quote to a 6% annual rate and compares it with a bank loan.
Example
A start-up rents 4,000 square feet of office space at a lease rate of $40 per square foot per year. Annual rent is 4,000 x $40 = $160,000, or about $13,333 a month. The founder checks whether service charges are extra before agreeing.
Example
A hospital leases an imaging machine under a five-year contract with a stated lease rate factor applied to the machine's price. The finance team compares total payments with the purchase price and the cost of maintenance. It chooses leasing because the technology may be replaced within five years.
Formula
Calculation
Monthly lease payment = (capitalised cost - residual value) / months + (capitalised cost + residual value) x money factor
A company leases a vehicle with a capitalised cost of $39,600 and an expected residual value of $23,400 after 36 months. The depreciation charge is ($39,600 - $23,400) / 36 = $16,200 / 36 = $450 a month. The finance charge is ($39,600 + $23,400) x 0.0025 = $63,000 x 0.0025 = $157.50 a month. The monthly lease payment is $450 + $157.50 = $607.50, and the equivalent annual rate is 0.0025 x 2,400 = 6%.Case study
Seen in the real world.
Cobalt Freight is an illustrative, fictional trucking company that received two quotes for leasing a truck worth $90,000. Lessor A quoted $1,500 a month for 60 months, and Lessor B quoted $1,380 a month for 60 months but with a $10,000 upfront payment and a lower residual value.
The finance manager calculated total cost: Lessor A cost 60 x $1,500 = $90,000, while Lessor B cost 60 x $1,380 + $10,000 = $82,800 + $10,000 = $92,800. Lessor B looked cheaper each month but cost $2,800 more over the term. The illustrative lesson is that comparing monthly payments alone can mislead, and the lease rate should be tested on the total cost.
Watch out
Common mistakes.
- Comparing offers on the monthly payment alone, without allowing for upfront fees, residual values and the length of the term.
- Confusing the money factor with an annual interest rate, when it has to be multiplied by 2,400 to give an approximate rate.
- Comparing gross and net property lease rates as if they were the same, when they cover different costs.
Questions
People also ask.
How is the lease rate different from an interest rate?
An interest rate applies to borrowed money, while a lease rate covers both the financing cost and the fall in value of the asset used.
What is a money factor?
It is a small decimal used by lessors to express the finance charge, and multiplying it by 2,400 gives the approximate annual percentage rate.
Why does residual value matter?
A higher expected residual value means the asset loses less value over the lease, so the depreciation part of the payment is lower.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related