What is residual value in asset finance and leasing?

How lenders use it

A higher residual means smaller rentals, because the customer pays for less of the asset's fall in value. It also means the lender takes more risk. If the asset is worth less than the residual when the contract ends, the lender may lose money.

Credit and asset teams set the residual by looking at the type of asset, its age and use, how easily it resells and what similar assets have sold for. Careful lenders set it low for assets that fall fast in value or that few people want.

Who carries the risk depends on the contract. In a hire purchase agreement the final payment is often a balloon that matches the residual, so the customer takes the risk. In a lease where the lender sells the asset, the lender may carry it. The credit memo should say how much of the lender's exposure rests on the residual and who bears the shortfall.

Lenders also check the residual again during the term. If used prices fall, the portfolio is worth less than the books say.

Worked example

Example only. A company leases a machine that costs £60,000 for four years. The lender sets the residual at 20%. That is £12,000. The rentals only need to cover the other £48,000 plus the lender's charges.

At the end, used machines like this sell for £8,000. The lender is £4,000 short. If the contract makes the customer pay a balloon of £12,000, the customer covers the gap. If the lender took the residual risk, the lender takes the loss.

Common confusions

Accountants use residual value too, but for a different reason. In a company's accounts, residual value is the amount the company expects to get for an asset at the end of its useful life, after costs of disposal. It is used to work out depreciation. A lender's residual is a forecast of resale value at the end of a contract.

Residual value is not net book value. Net book value is cost minus depreciation charged so far. It follows an accounting rule, not the market.

US writers often say salvage value or scrap value for the accounting figure. In US car and equipment leasing, residual value usually means the lender's end-of-lease value, as in the UK.

Questions lenders ask

What is the 90% rule in leasing?

It is an accounting test from US lease standards. A lease is usually counted as a finance lease when the present value of payments is at least 90% of the asset's fair value. It tells the customer how to book the lease. It is not a lender's rule for setting a residual.

How does a lender set the residual value?

It looks at the asset type, age, expected use and the used market. It compares the price of similar assets and sets the figure with a margin for error. Many lenders check it against third-party price guides or valuations.

What is a balloon payment?

A balloon is a larger final payment. In hire purchase and some finance agreements it often equals the residual value. The customer pays it to keep the asset, or sells the asset and settles the balloon from the proceeds.

Who loses if the asset is worth less than the residual?

The contract says. In a lease where the customer must pay any shortfall, the customer does. If the lender kept the residual risk, the lender takes the loss. Read the agreement and record the answer in the credit file.

Hire purchase vs lease: Who owns the asset at the end
Debenture: Security over a company's assets
Personal guarantee: An owner's promise to repay if the company cannot
Credit memo: The lender's written case for a credit decision

This page is general information for lenders. It is not legal, tax or credit advice.