Do you know what is implicit interest rate is all about? Well, 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.
Implicit Interest Rate Meaning and Definition
An implicit lease rate is actually an interest rate that you need to pay when getting a loan. But that interest rate is not mentioned in the borrowing agreement.
Because the borrower needs to pay back more than they borrowed, but the borrower didn’t see any interest is stated in the loan contract or agreement. Because of this, we are calling it an implicit interest rate.
While one most likely won’t 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
Calculating implied interest in a lease isn’t beneficial if the lessee can’t put that information into context. Thus, before getting into the mathematical details, it’s helpful to put borrowing 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, make up the lessee’s payments.
When the lease is up, the return of the asset is considered a repayment of the principal. This example is as simple as returning the car, which is now worth $15,000.
How to Calculate Implicit Interest Rate in a Lease?
Before making the calculations, you should note that a financial calculator, many freely available online, is recommended. Algebraic formulas for calculating the implicit rate of return 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 asset’s future value, which will be worth it when you return it. For our case, that will be $15,000.
Now that the values are pinned down, all 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 implied interest rate and period 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.
Another Example
Let’s say you want to buy a car that has a selling price of $15,000. But you don’t have $15,000 to pay for that car. So you make a lease to buy the car.
Under the conditions of your lease, you need to pay $2,000 upfront when you buy the car. Then, you will need to pay 3 annual installments of $5,000. Starting after one year, you can easily calculate that in total.
You will pay $15,000 over the lease term of 3 years. After 3 years, your total payment is like this:
- Year 0: $2,000
- Year 1: $5,000
- Year 2: $5,000
- Year 3: $5,000
From there, you can know that the total amount that you pay is $17,000. This is more than what you pay for the initial selling price of the car.
This is because the lease that you get is actually a loan. So you need to pay interest on it. The lease has been split into the loan principal so that you won’t realize the interest. But you are actually have paid $2,000 for the interest implicitly.
Simple Implicit Lease Rate Formula
If you want to know how the rate is being calculated, here is the simple formula that you can use:
(Interest ÷ Principal) x 100 = Interest Rate
Let’s say you are borrowing a personal loan of $5,000 from a bank, and you need to pay it back as an installment in 12 months. The monthly payment is $500.
In your personal loan with the bank, there is no interest rate being stated. So this can be said to be an implicit interest rate.
We can apply the formula mentioned above if we want to know the additional rate percentage we have paid after 12 months.
- Interest: [($500 x 12) – $5,000] = $1,000
- Principal: $5,000
So the calculation will be:
($1,000 ÷ $5,000) x 100 = 20%
How To Calculate Implicit Interest Rate Lease in Excel File
You can also open a spreadsheet like Microsoft Excel and do the calculation for the implicit interest. What you need to do is open a blank sheet, then key in the below number:
Said you have a car loan of $20,000. You need to repay with a monthly installment of $600, and the number of repayment is 5 years. So you can use a formula like this one:
=RATE(5*12,-600,20000)
Once you key in all the amounts in the Excel sheet, you can copy the formula and change it to match your loan. Then hit the “Enter” key. The calculation will show you what is the annual implicit interest rate for your loan is.
From the calculation above with the formula that we put in the Excel sheet, we know that the loan has an implicit interest rate of 2% per annum.
Lease Implicit Interest Rate Calculator
Once you know how to calculate a lease accounting 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.
Read also: Know more about Annual Percentage Rates (APR)
What is Capital Lease Implicit Interest Rate?
A capital lease is normally involved in a company leasing a fixed asset but not purchasing it. They don’t want to purchase but lease the fixed asset instead because the vendor offers attractive lease terms. The company wants to have a better accounting result for their profit and loss or other reasons.
With such a lease, an interest rate will be incurred for that lease and need to be paid monthly.
Finance Lease
Financial Leasing, also known as Equipment Leasing or Modern Leasing, refers to a lease that substantially transfers all or most of the risks and rewards associated with ownership of an asset. The ownership of the asset may or may not be transferred.
Suppose you want to know how the financial leasing is, you can read the lease agreement. You can be easily spot on if there is a finance cost tied up within the transaction.
Financial lease implicit interest rate example
For instant, a company may purchase an asset that having 5 years of useful economic life. The price is $15,000. Alternatively, the company also can choose to lease that asset for 5 years by paying the leasing fee of $3,500 per annum. The total payment after 5 years will be ($3,500 x 5) = $17,500.
The difference between the finance lease and purchase of the asset would be $17,500 – $15,000 = $2,500.
So the $2500 is the finance lease implicit rate for leasing the asset for 5 years.
Operating Lease
An operating lease also is known as a business lease. It is a leasing business that leases its products from the leasing department or professional leasing company of a large-scale manufacturing company.
The lessor generally has its own rental warehouse, and once the tenant requests it, you can directly rent out the equipment to the user. The user pays the rent according to the lease and returns the equipment after the lease expires.
Operating lease implicit interest rate example
Company A signed an agreement with Company B to lease a piece of equipment with an estimated life of 10 years. The lease period is for 5 years. The rental is $10,000 per annum. The equipment’s initial value is $50,000. The equipment is expected to depreciate to $0 after 10 years.
For this one, generally, Company B can request payment once the agreement is signed. This is considered Year 0.
For example, Company A pays Company B $5,000 after signing the agreement.
So the payment will go like this:
- Year 0: $5,000
- Year 1: $10,000
- Year 2: $10,000
- Year 3: $10,000
- Year 4: $10,000
- Year 5: $10,000
The total payment is $55,000. When deducting the equipment value of $50,000, the implicit interest rate will be $5,000.