Written byResidual value is the amount a leased car or asset is expected to be worth when the lease ends, set at the start and used to calculate the rentals.
Also known as: residual, lease residual, residual payment
Key points
- The higher the residual, the lower the rentals, because less of the asset's cost is repaid during the term.
- In Australia the ATO publishes minimum residual values for leases, which fall as the lease term gets longer.
- On a finance lease or novated lease the lessee is responsible for the residual at the end of the term.
- It is not a balloon payment, which is a contracted lump sum on a loan; salvage value is the same estimate at end-of-life.
How residual value works
When a lease is written, the financier estimates what the asset will be worth when the term ends. That figure is the residual value. Your rentals are calculated to repay the difference between the purchase price and the residual, plus the financier's finance charge, so a bigger residual means smaller rentals and more owing at the end.
Residuals are usually expressed as a percentage of the purchase price. The ATO publishes minimum percentages for each lease term so that a lease is not used to disguise a purchase. Financiers keep the residual at or above the minimum, because a lower figure risks the arrangement being treated as a sale or hire purchase rather than a lease.
What happens to the residual at the end
On a finance lease or a novated lease you carry the residual. You can pay it and keep the asset, refinance it into a new agreement, or sell the asset and use the proceeds to clear it. If the sale price is lower than the residual, you pay the shortfall; if it is higher, you keep the difference.
On an operating lease the lessor carries the residual risk: you return the asset and the financier deals with whatever it is worth.
Residual risk and how to manage it
The gap between the residual and the asset's real value at the end of the term is residual risk. Cars that hold their value well, longer terms with lower residual percentages, and keeping the asset in good condition all reduce it. Some financiers offer a residual value guarantee or insurance for a fee.
Before signing, ask what the residual is in dollars, what the asset is likely to sell for at the end of the term, and what happens if there is a shortfall.
Example
An employee takes a four-year novated lease on a $40,000 car. The financier sets the residual at the ATO minimum for a four-year term, 37.5%, which is $15,000. The rentals repay the other $25,000 plus the finance charge over the four years. At the end, the employee can pay the residual and keep the car, refinance it, or sell the car and use the proceeds to clear it.
Not to be confused with
- Balloon payment
- a balloon payment is a contracted lump sum at the end of a loan; a residual value is the estimated worth of a leased asset that the lessee may have to cover
- Salvage value
- salvage value is the informal name for the same estimate under AASB 116, taken at the end of the asset's useful life rather than the end of a lease term
Frequently asked questions
What is a residual value example?
A three-year lease on a $50,000 vehicle might set the residual at just under $23,500, in line with the ATO's minimum for a three-year term. The rentals repay the other $26,500 or so plus the finance charge, and at the end the lessee pays the residual, refinances it, or sells the car to cover it.
What is the residual value on a car lease?
It is the amount the car is expected to be worth when the lease ends, set at the start as a percentage of the purchase price. On a novated or finance lease you are responsible for it: pay it and keep the car, refinance it, or sell the car and cover any shortfall.
Is a high residual value good or bad?
It cuts both ways. A higher residual means lower rentals during the term, but more to pay at the end and a bigger gap to cover if the car is worth less than expected. A lower residual costs more each month and leaves less owing. The right level depends on your cashflow and how well the asset holds its value.
How is residual value calculated?
Financiers estimate the asset's future market value, then apply the ATO's minimum residual percentages for the lease term as a floor. The residual is expressed as a percentage of the purchase price, and the rentals are calculated on the purchase price minus the residual, plus the finance charge.
What are the ATO minimum residual values?
The ATO publishes minimum residual percentages for leases by term. They start at about two-thirds of the cost for a one-year lease and fall each year, reaching a little under 30% for a five-year lease. Financiers keep the residual at or above these percentages, because a lower figure risks the ATO treating the lease as a sale rather than a lease. The current percentages are on the ATO website.
Related terms
Narrower terms: Residual value guarantee (RVG), Residual value insurance
Balloon payment
A balloon payment is a lump sum, agreed upfront, that is paid at the end of a loan term and lowers the regular repayments by deferring part of the principal.
Read definitionNovated lease
A novated lease is a three-way car lease where your employer takes over the lease payments and deducts them from your salary, mostly before tax, while you work there.
Read definitionFinance lease
A finance lease is a lease where the financier owns the asset and your business pays to use it for most of its life, taking on the risks of ownership.
Read definitionOperating lease
An operating lease is a lease where you pay to use an asset for a set term and hand it back, with the financier keeping ownership and the resale risk.
Read definitionResidual risk
Residual risk is the exposure that remains after controls have been applied to an inherent risk: the risk an organisation must still accept, transfer or treat further.
Read definitionResidual value guarantee (RVG)
A residual value guarantee (RVG) is a lessee's or third party's promise to pay the lessor any shortfall if a leased asset sells for less than its agreed residual.
Read definitionGo deeper
Sources
This article is general information only and is not financial advice.