Which is better, a lease or a loan? This is a question that comes up all the time, and frankly, one is no better than the other. A lease and a loan are actually very similar in that they are both a means of financing the purchase of equipment.
That said, a loan is often viewed as a method of purchasing equipment, and a lease is viewed as a method of payment for the use of equipment. That is true, however, both are a legal financial obligation to make payments for a fixed period of time. Under a loan agreement, the user has ownership of the equipment, while under a lease, the ownership of the equipment is in the hands of the Lessor, also known as the leasing company.
Many companies want to own equipment and simply want to buy it outright. In reality, if a loan is used to purchase equipment, they do in fact have title to the equipment, however, they do not actually own the asset until the final payment is made.
Over the past few years, the term “Lease-to-Own” has become very popular and, in fact, many leasing companies are offering advantageous end-of-term purchase options. When this is the case, the lessee should be cautious in the accounting treatment of the lease, since the Government may interpret it as a loan contract.
From an accounting point of view, equipment acquired under a loan agreement appears as an asset on the balance sheet, however, it is offset by a related debt liability. In the case of leased equipment, the asset does not appear on the balance sheet and the associated lease payments do not appear as debt but as an expense in the income statement. Leasing is often referred to as off-balance sheet financing, and in turn, it has a positive effect on some of the financial ratios, such as debt and equity.
Let’s take a look at some of the areas to consider when making a decision about whether to use a loan or lease to finance equipment.
At face value, the implicit interest on a loan will be less than that of a lease. In fact, the loan rates provided by banks are lower than those of the leasing division of the same bank. However, lease payments are generally fully tax deductible, and when a proper loan versus lease analysis is done, the after-tax interest rate is much lower in a lease scenario.
Most banking institutions require between 10% and 25% of the cost of the equipment as a down payment. On the other hand, a finance leasing company will generally provide 100% financing and will only require the first or first and last payment at the start of the contract. An exception to this can occur when the financial fitness of a business is marginal, a leasing business may require a down payment to carry out the lease.
Additional credit facility
When evaluating an equipment loan, a bank will generally consider the total amount of outstanding debt owed to a particular customer, which is often referred to as exposure. Banks have exposure limits based on the financial size and strength of the organization, as well as its operating history. Exposure is always taken into account in your credit decisions. If a loan increases exposure to the upper limit, it can inhibit the additional use of conventional bank lines of credit for normal operating expenses. By using a third-party leasing company to finance the purchase of equipment, a company can preserve its conventional lines of credit in the moment and, in effect, create a new line of credit.
Most bank loans have many restrictions and covenants, such as maintaining certain financial ratios, restrictions on future debt, and salary restrictions. Also, look for the “Call” provisions that banks incorporate that give them the right to demand a prepayment of your loan for reasons over which you have no control. Leasing does not have any of these types of provisions.
General security agreement
Depending on a number of factors, a bank will often file a General Security Agreement, granting you a collateral in all of the company’s assets, both those it currently owns and those acquired in the future. This restricts our assets, including inventory and accounts receivable, and can inhibit dealing with suppliers and other financial institutions. In the case of a leased asset, the lessee files a document called a Personal Property Security Agreement, or PPSA, which provides them with interest only in the leased asset.
In the case of a loan, the asset is capitalized and appears as an asset on the balance sheet. From a tax point of view, depreciation and interest on the loan are written for tax purposes. Assets are classified into classes and each class has a different allowable depreciation rate. In the first year of the loan, you can only pay off 50% of the depreciation, as well as the interest portion of the loan. In subsequent years, depreciation can be written off on a declining balance basis.
Leases, on the other hand, are treated as an expense in the income statement, and payments are usually paid in full. This dramatically speeds up tax cancellation and provides a tremendous tax effect on a conventional bank loan.
In summary, there are advantages and disadvantages to equipment financing under both a loan and a lease agreement. Every situation is different and as a result a proper analysis must be done before making a decision.