Understanding Lease Payments: Types, Terms, and Definitions

What Are Lease Payments?

A lease payment is the recurring amount paid for the right to use an asset, like property, equipment, or software, without owning it. Payment levels depend on factors such as asset value, creditworthiness, and contract terms, which may span from monthly agreements to long land leases. Different lease types also vary in what they include, such as whether maintenance is covered.

How Lease Payments Work

Lease payments can be made by individuals as well as companies. Individuals traditionally use leases to finance cars, but they may also use them to obtain the use of computer equipment, tracts of land, and other physical assets. A lease payment amount is determined by a variety of different considerations, such as an asset's value, local residual values in a given neighborhood, discount rates, and a lessee's credit score.

A company's lease payments are used in the calculation of the fixed-charge coverage ratio, which helps investors determine if a company is able to cover its fixed expenses, such as leases and interest. The fixed charge coverage ratio is essentially an amplified version of the times interest earned ratio, or the times interest coverage ratio. It's highly adaptable for practical usage, with nearly all fixed costs, since these fixed costs are so similar to lease payments.

Exploring Different Types of Lease Agreements

The most common types of lease agreements are as follows:

• Operating leases
• Financial leases (also called capital leases)
• Sale-and-leaseback arrangements
• Combination leases (those which marry two or more of the aforementioned models)

The most significant characteristic of an operating lease is that it allows for both financing and maintenance, in which lease payments include an element for financing charges as well as maintenance components. Operating leases require lessors to regularly service the leased equipment in question. For example, it is not uncommon for aircraft owners to lease out their jet engines.

In many cases, the owners don't possess the technical knowledge required to maintain the parts for themselves, because the components are highly specialized. In such cases, it behooves owners to include maintenance charges directly with lease payments.

Financial leases differ from operating leases in that they do not embed maintenance fees in the lease payments. Newer leases types, which often offer more customized service levels and lease payment structures, include synthetic leases, and leases tied to mileage, hours, or usage levels. For example, General Electric often leases expensive locomotive components with lease payments that are tied to mileage. In theory, a lessee is only paying for what they need.

The Bottom Line

Lease payments are recurring fees that allow temporary use of an asset without ownership, spanning operating leases, finance leases, and sale-and-leaseback arrangements.

Terms vary in maintenance coverage, payment structure, and duration, from short contracts to long committments. Individuals and businesses use leases for flexibility, whether monitoring mileage limits on car leases or assessing affordability with measures like the fixed-charge coverage ratio.