What are lease payments?

Unlike loan repayments, which buy the asset over time, lease payments buy the right to use it. A typical payment funds part of the asset's value, the finance charge on the lease liability, and administration or establishment fees. Some leases also bundle comprehensive insurance, servicing and tyres. GST is added where it applies, and a refundable security deposit paid upfront reduces the later instalments.

The payment profile can be level, with the same amount each period, stepped to match cashflow, variable with an index or usage, or a combination of a fixed monthly amount plus usage charges. Most leases also carry a residual at the end, and early termination or disposal costs if you end the lease early or return the asset in poor condition.

The common structure is a level payment with a residual value at the end of the term. The payments only need to cover the capitalised cost, which is the asset price less any deposit, minus the present value of the residual, plus the periodic finance charge. So a higher residual lowers each payment but raises end-of-term risk, and a longer term lowers each payment but increases the total interest paid. Small changes in the rate move the payment materially, so compare effective rates and total cost rather than the advertised monthly figure.

To manage the payment, you can put in a larger deposit, negotiate the residual, extend the term, limit bundled add-ons, or buy insurance separately if that is cheaper. Watch for excess kilometre and wear-and-tear charges, indexation clauses on long leases, and accessories rolled into the capitalised cost.

Where a business reports under the Australian Accounting Standards, AASB 16 puts most leases on the balance sheet as a right-of-use asset and a lease liability, measured at the present value of the lease payments. Short-term leases of 12 months or less and low-value assets are exempt. Each payment is split between interest and a reduction in the liability, and the right-of-use asset is depreciated separately. Variable payments not based on an index or rate are generally expensed when incurred. Lessors still classify leases as finance or operating.

For tax, lease payments, or the depreciation and interest split on a capitalised lease, are generally deductible where they are incurred in producing assessable income. Lessors normally charge GST on each payment, and a GST-registered lessee can claim input tax credits to the extent the asset is used in the business. Under a novated lease the employer makes the payments from salary and fringe benefits tax can apply. Check the ATO's guidance or your accountant for your structure.