In every lease, whether it be a $3,000,000 piece of manufacturing equipment or a $20,000 car, there is an implicit interest rate that lessees pay to lessors. While one most likely won’t be able to find it explicitly stated in the highlights of the contract terms, the interest is always there, buried within the numbers and calculations of the lease. From a logical perspective it makes sense that this exists, otherwise lessors wouldn’t be able to stay in business. By finding the implied interest rate in their contract, lessees can see what they’re truly paying for the right to use an asset, and, armed with that information, they might even be able to negotiate better terms.
The Basics of Implicit Interest Rate
Being able to calculate implied interest in a lease isn’t very beneficial if the lessee can’t put that information into context. Thus, before getting into the mathematical details, it’s helpful to put lease rates into perspective. Basically, purchasers can think of their lease as a loan. The initial value of that loan is the leased asset’s value. So, if it’s a $20,000 car being leased, that $20,000 is essentially the principal. During the life of the lease, the lessee makes payments to cover the depreciation of the asset plus interest. Imagine the lessor of the $20,000 car thinks that it will be worth $15,000 when the lease terminates. That $5,000 difference, plus the interest we’ll calculate later, makes up the lessee’s payments. When the lease is up, the return of the asset is considered a repayment of the principal. In this example, it’s as simple as returning the car, which is now worth $15,000.
How to Calculate Implicit Interest Rate?
Before making the calculations, it should be noted that a financial calculator, of which there are many freely available online, is recommended. Algebraic formulas for calculating interest rates tend to err on the big and hairy side, so unless you’re really into math the financial calculator will be your friend.
There are four values needed to solve for interest in the formula. The first is the present value of the asset you’re leasing. If it’s the $20,000 car mentioned earlier, $20,000 is the present value. The second constant necessary is the value of monthly payments. This, fortunately, is self-explanatory. Let’s assume the payments for our 3 year lease on the $20,000 car are $300 monthly. Next is the number of payment periods in the life of the lease. Often abbreviated “n”, it would be 36 for our example’s 3 year lease with monthly payments. Lastly is the future value of the asset, which is what it will be worth when you return it. For our case, that will be $15,000.
Now that the values are pinned down, all that’s left to do is plug them into a financial calculator. Our number of periods is 36, present value is $20,000, payment value is $300, and future value is $15,000. Some calculators might ask for payments per year, which for a monthly lease is of course 12. Press the “enter” button, and you’ll find that the implied interest rate for this lease is 10.9% annually.
Implicit Interest Rate Calculator
Once you know how to calculate a lease’s implicit interest rate, you can shop around for the best contracts available. Interest, in essence, is the true cost of asset rental, and being able to identify it is a great tool for any lessee to have.
If you want to know more, you may refer to Wikihow for more examples on the calculations and also learn how to calculate implicit interest rate lease in excel spreadsheet.