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Equipment Leasing: What It Is and How It Works

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Equipment leasing is a popular financing option for small businesses that need access to essential machinery and tools without the significant upfront costs associated with purchasing equipment outright. This comprehensive guide will explore the concept of equipment leasing, its various types, advantages, and disadvantages, and help you understand how it works.

Key takeaways

Equipment leasing is a long-term rental agreement where a business (the lessee) rents a piece of equipment from a leasing company or another lender (the lessor) for a specific period. The lessee makes regular payments throughout the lease term, and at the end of the agreement, the equipment is either returned to the lessor, the lease is renewed, or the lessee purchases the equipment, depending on the type of lease.

The two main types of equipment leases are capital leases and operating leases. Capital leases are long-term agreements that often include a purchase option, while operating leases are shorter-term rentals without a purchase option.

Leasing equipment offers several benefits, such as lower upfront costs, flexibility to upgrade equipment, and potential tax advantages. However, it's essential to consider the downsides, such as higher overall costs compared to purchasing, lack of ownership, and potential early termination fees.

Businesses should carefully evaluate their needs and financial situation when deciding between leasing and financing equipment to ensure they make the most suitable choice for their operation.

What is equipment leasing?

Equipment leasing is an arrangement in which a business (the lessee) rents a piece of equipment from a leasing company, lender, or vendor (the lessor) for a predetermined period. The lessee makes regular payments, usually monthly, to use the equipment while the lessor retains ownership. At the end of the lease term, the lessee typically has the option to renew the lease, purchase the equipment, or return it to the lessor, depending on the type of lease agreement.

Various types of equipment can be leased, including construction and heavy machinery, farm equipment, medical and dental equipment, office equipment and technology, restaurant equipment, and vehicles. The lease term can range from a few months to several years, with common terms being 24, 36, 48, and 60 months.

Types of leases

There are two primary types of equipment leases: capital leases and operating leases.

A capital lease is a long-term agreement that typically spans most of the equipment's useful life. It often includes an option for the lessee to purchase the equipment at the end of the lease term. In a capital lease, the lessee is generally responsible for maintenance, taxes, and insurance related to the equipment.

An operating lease, on the other hand, is a shorter-term rental agreement where the lessee uses the equipment without the intention or option to purchase it at the end of the lease. The lessor typically retains responsibility for maintenance, and the lessee returns the equipment upon lease completion.

Cancellation provisions.

Lease agreements may include cancellation provisions that outline if and when the lease can be terminated and any associated fees or penalties. It's crucial for businesses to carefully review and understand these provisions before signing a lease agreement to avoid unexpected costs in case of early termination.

Cost of equipment leasing

Fee Description
Down Payment An initial payment made at the start of the lease to secure the equipment.
Documentation Fee A fee charged to cover the cost of processing the lease agreement paperwork.
Maintenance Fee A fee for regular maintenance services included in the lease agreement.
Early Termination A penalty fee for ending the lease before the agreed-upon term.
Lease Extension Fee A fee charged if you extend the lease term beyond the original agreement.
Setup Fee A fee for the installation or setup of the leased equipment.
Wear and Tear Fee Charges for excessive wear and tear on the equipment beyond normal use.
Upgrade Fee A fee for upgrading to newer equipment during the lease term.

The cost of equipment leasing is primarily determined by the depreciation rate of the equipment, along with fees and taxes. The lessor charges a money factor, similar to an interest rate, which is multiplied by the financed amount plus the residual value of the equipment to calculate the monthly rent charge. This rent charge is then added to the monthly depreciation to arrive at the final lease payment.

Additional costs may include a down payment (often first and last month's payment), documentation or processing fees, appraisal or site inspection fees, insurance, maintenance costs, and transportation or assembly costs.

Pros and cons of equipment leasing

Pros Cons
Flexibility in upgrading to new equipment. No ownership at the end of the lease term.
Conserves working capital for other investments. Potential for higher interest rates.
Simplified budgeting with fixed monthly payments. Equipment must be returned in good condition.
Potential for maintenance and service packages. Possible penalties for early termination.
Access to the latest technology. Limited customization options for leased equipment.

Pros:

  • Lower upfront costs and monthly payments compared to purchasing
  • Flexibility to upgrade equipment as needed
  • Potential tax deductions for lease payments
  • Possibility of 100% financing with no down payment

Cons:

  • Higher overall cost compared to purchasing the equipment outright
  • No ownership of the equipment at the end of the lease
  • Potential early termination fees if the lease is ended prematurely
  • Equipment is not considered an asset on the business's balance sheet

Qualification criteria.

To qualify for equipment leasing, businesses typically need to meet certain criteria, such as:

  • Minimum credit score: 520-650, depending on the lender and type of lease
  • Annual revenue: Minimum of $50,000, with some lenders requiring $100,000 or more
  • Time in business: Startups may qualify, but established businesses with at least two years of operation often have better chances

Additional criteria may apply for leasing used equipment, such as restrictions on age or mileage.

Equipment leasing formula.

The formula for calculating monthly lease payments is as follows: ((Finance Amount + Residual Value) * Money Factor)) + Monthly Depreciation + Taxes = Monthly Lease Payment

How equipment leasing works

A master lease is an agreement that allows a business to lease additional equipment from the same lessor without negotiating new contracts for each piece of equipment. This can be advantageous for businesses planning for near-term growth and needing to acquire multiple pieces of equipment over time.

What is a master lease?

A master lease is an agreement that allows a business to lease additional equipment from the same lessor without negotiating new contracts for each piece of equipment. This can be advantageous for businesses planning for near-term growth and needing to acquire multiple pieces of equipment over time.

What is an operating lease?

An operating lease is a short-term rental agreement where the lessee uses the equipment for a set period without the intention or option to purchase it at the end of the lease. The lessor typically retains responsibility for maintenance, and the equipment is returned to the lessor upon lease completion. Operating leases do not appear on the lessee's balance sheet.

What is a capital lease?

A capital lease is a long-term agreement that spans most of the equipment's useful life and often includes a purchase option at the end of the lease term. In a capital lease, the lessee is generally responsible for maintenance, taxes, and insurance related to the equipment. Capital leases are recorded on the lessee's balance sheet.

Equipment leasing vs. equipment financing

Equipment financing involves using a loan or line of credit to purchase equipment outright, with the equipment serving as collateral for the loan. The key difference between leasing and financing is that with financing, the business owns the equipment once the loan is paid off, while with leasing, the lessor retains ownership unless a purchase option is exercised.

Equipment Lease Equipment Loan
Monthly rental fee Monthly payment including principal and interest
No down payment required Often requires a down payment
Maintenance and upgrades often included Maintenance and upgrades are the owner's responsibility
Flexible terms and easier to upgrade Fixed terms with less flexibility for upgrades
Lower initial cost Potential for equity and ownership
Ideal for short-term or rapidly evolving needs Ideal for long-term, stable equipment needs
No ownership, equipment returned at lease end Equipment owned outright after loan repayment
Easier approval process May require stronger credit and financials

Is it cheaper to lease or buy equipment?

The decision to lease or buy equipment depends on various factors, such as the cost of the equipment, the length of time it will be used, and the business's financial situation. Leasing may be more affordable in the short term due to lower monthly payments and little to no down payment. However, purchasing equipment can be more cost-effective in the long run, as the business owns the asset outright and can benefit from its residual value.

Capital lease vs. operating lease.

The main differences between capital leases and operating leases are:

  • Lease term: Capital leases are long-term agreements that span most of the equipment's useful life, while operating leases are shorter-term rentals.
  • Purchase option: Capital leases often include a purchase option at the end of the lease term, while operating leases generally do not.
  • Balance sheet treatment: Capital leases are recorded on the lessee's balance sheet, while operating leases are not.
  • Maintenance responsibility: In a capital lease, the lessee is typically responsible for maintenance, taxes, and insurance, while in an operating lease, the lessor usually retains these responsibilities.

How to find equipment leasing

Businesses have several options when it comes to finding equipment leasing:

Banks and financial institutions

If a business already has a relationship with a bank or financial institution, they can inquire about equipment leasing options. Banks often charge lower fees compared to other leasing companies.

Equipment dealers and distributors

Equipment dealers and distributors may offer leasing services through subsidiary leasing companies. Businesses can visit their websites or contact them directly to learn about available options.

Independent leasing companies

Businesses can work directly with independent leasing companies that specialize in equipment leasing. Obtaining quotes from multiple companies can help businesses compare terms and find the best fit for their needs.

Equipment brokers

Equipment brokers have relationships with manufacturers, retailers, and lenders, and can connect businesses with equipment owners. However, they charge a fee for their services.

Can you write off equipment lease expenses?

Equipment lease payments can generally be deducted as a business expense on taxes, as long as the agreement is a true lease and not a conditional sales contract. The IRS considers factors such as whether the lessee receives the title after a certain amount is paid or has the option to buy the equipment for a nominal price when determining if an agreement is a true lease.

In a true lease, the lessor claims the tax deductions associated with depreciation, while in a conditional sales contract, the lessee is considered the owner and can typically take depreciation deductions instead of deducting rent payments.

Requirements for equipment leasing and financing

To qualify for equipment leasing or financing, businesses typically need to meet the following requirements:

  • At least two years in business
  • Personal credit score of 600 or higher
  • Annual revenue of $100,000 or more

Additional requirements may apply depending on the lender, the type of equipment, and whether the equipment is new or used.

Steps to get an equipment lease.

  1. Identify the specific equipment needed for the business operation.
  2. Research and compare leasing companies that cater to the business's needs and equipment type.
  3. Obtain quotes from multiple leasing companies to compare terms and rates.
  4. Carefully review and understand the terms of the lease agreement, including duration, payments, end-of-lease options, and cancellation provisions.
  5. Apply for the lease by providing the necessary business and financial information.
  6. Upon approval, review the lease terms once more and sign the agreement.
  7. Take possession of the equipment and begin using it for the duration of the lease.

Bottom line

Equipment leasing is a valuable financing tool for businesses that need access to essential machinery and tools without the high upfront costs of purchasing. By understanding the types of leases, their advantages and disadvantages, and the leasing process, businesses can make informed decisions that best suit their needs and financial situation. It's crucial to carefully consider factors such as the length of the lease, the total cost over the lease term, and the business's long-term equipment needs when deciding between leasing and financing.

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Written by
Henry Arora
Head of Business Development

Experienced Manager with a demonstrated history of working in the Fintech/Customer services/Debt Collections industry. Skilled in Management, Debt Collections Sales, Leadership, Team Management, and Public Speaking. Strong operations professional graduated from Madhurai Kamraj University.

  • Fintech/Customer services Expert
  • Public Speaking
  • Debt collection Expert

FAQ

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What is the difference between equipment financing and leasing?

Equipment financing involves borrowing money to purchase equipment outright, while leasing involves renting the equipment for a set term with the option to purchase or return it at the end of the lease. Financing typically results in ownership of the equipment, while leasing may not.

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Is it better to lease or finance equipment?

The decision to lease or finance equipment depends on various factors, such as the type of equipment, the length of time it will be used, and the business's financial situation. Leasing may be a better option for equipment that becomes obsolete quickly or is needed for a short period, while financing may be preferable for long-term use and building equity in the asset.

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What are the disadvantages of leasing equipment?

The main disadvantages of leasing equipment include:

  • Higher overall costs compared to purchasing the equipment outright
  • Lack of ownership at the end of the lease term
  • Potential early termination fees if the lease is ended prematurely
  • Leased equipment does not appear as an asset on the business's balance sheet

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