Equipment Loan vs Lease

The names vary by country and by financier, and the first two collapse into one in most conversations; what does not vary is the shape. The equipment finance file on this site takes the loan through a credit desk in full — the amount sized to the asset, the tenor to its working life, the balloon to its resale value. This page is the comparison with the alternatives, from the borrower's chair.

Strip the names away and every structure answers two questions: who owns the asset when the payments stop, and who carries the residual value risk — the chance that on that day the asset is worth less than the amount left riding on it. A loan gives you the asset and the risk. An operating lease gives the financier both. A finance lease gives the financier the title and you the risk, which is the arrangement most often misunderstood, because the business does not own the machine and still owes the shortfall if it sells badly.

How much risk that is depends on the asset, not the contract. An asset's value is a property of who else could use it: eighteen generic linehaul trucks can be sold to any carrier in the country, and a distribution-centre fit-out built for one operator's racking is worth what the next tenant will pay for it, which may be nothing — the reading Issue 05 turns on. Whoever carries the residual on a specific asset is carrying most of its cost; whoever carries it on a generic one is carrying a market.

The rate is the visible cost and the residual is where the money hides. A loan shows its interest rate; a lease shows a payment, from which the rate has to be worked out, and a lease payment set low is usually low because the residual is high. Then the end-of-term conditions: a return condition on a rental — hours, wear, refurbishment — is a cost paid on the last day; a residual on a finance lease is a cost paid or refinanced on it; a balloon on a loan is the same. Deposits differ: a loan usually wants the business's own money in the asset from the start, a lease may not, and that difference is sometimes the whole reason a growing business leases.

Two things this page will not decide for you. Accounting standards now bring most leases onto the lessee's balance sheet, so the old distinction between debt on the books and rent off them has largely gone; and the tax treatment of each structure differs by country and by how the contract is written. Both belong with your accountant before you sign, not after.

As debt, whatever it is called. A credit analyst adds lease payments to the fixed commitments the business must meet whether or not it trades well and tests cover on the total — the fixed charge cover ratio — because a lease default disturbs a business as surely as a loan default does. The desk reads the lease's term against the asset's useful life to the business, the residual against what the asset would honestly sell for, and the financier behind the lease as another creditor with a registered claim on an asset the bank's general security will not reach.

Which is why the facility letter usually has something to say about it: a negative undertaking that no new security is given, or no new borrowing taken, without consent — and a lease is both. A business that takes a fleet on lease and mentions it at the annual review has, as far as the desk is concerned, told it late. The conversation before is short and the conversation after is not.

Lease when the asset dates faster than it wears — computing, some vehicles, medical and printing equipment — so that handing it back on a known cycle is the point; when the business would rather the financier carried the residual, and is willing to pay for that; when a deposit is the constraint; or when the use is shorter than the asset's life, as with a contract that ends. An operating lease with a return condition is a way of renting a replacement cycle.

Borrow when the asset will earn for the business well beyond the loan — plant, a press, a truck the business will run into its second decade; when you want to own it, modify it or sell it on your own timetable; when its resale market is broad enough that carrying the residual is a reasonable risk; and when the total cost matters more than the monthly payment, because a loan is usually cheaper over the asset's whole life for a business that keeps it. The shape of the finance follows the shape of the need, as Line of Credit vs Term Loan puts it for the other end of the balance sheet.

Buying it on the overdraft. A machine paid for out of years of earnings, funded on a line meant to return to zero; the line never does, and the bank reads a term loan at an overdraft's price. A balloon on a specific asset. A residual set to the payment the business wanted rather than to what a machine built to one customer's specification will sell for. A lease longer than the use. A five-year lease on equipment for a three-year contract, and two years of paying for a machine that is idle. Ignoring the return conditions until the refurbishment invoice. Treating the lease as invisible — to the accounts, to the covenant and to the bank — when the desk will count it, and count the surprise. Sale-and-leaseback as a cash substitute. A business that sells the plant it already owns and leases it back has raised cash and added a fixed charge, and a desk reads the second as carefully as the first.

Ask who should own the asset on the last day, and who should be holding it if it sells badly. If the answer to both is you — because the asset earns for years and its market is broad — borrow, and set the balloon to an honest resale value or none. If the answer to both is the financier — because the asset dates, or the use ends — lease, and read the return conditions before the rate. If the answer is split, a finance lease is what you are being offered, and you should know that you are carrying the residual on a machine you do not own. Then tell your bank before you sign, and let it read the payment beside your other fixed commitments with you rather than after you.