What Is a Finance Lease?

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When businesses or people need new things, they typically buy them, either out right with cash, or via a loan. But, when that isn't the best option, for whatever reason, leasing is an alternative. A financial lease allows for the necessary equipment or objects to be acquired without actually buying them. Instead, a leasing company buys the items and then allows the borrower to use them in exchange for payments which cover both the expense of part of the item, and an interest rate.

Function

A financial lease allows a business to acquire equipment or other property for use over a specific time frame without having to buy the equipment.

Types

A financial lease is one in which the lessee is responsible for all operation, maintenance, and upkeep of the equipment. The lessor, in contrast, provides nothing other than the capital needed for the item. This is in contrast to a service lease, or operating lease, in which the lessor is responsible for the operation and maintenance of the property in question, as is usually the case with office space.

Time Frame

A lease can be for any amount of time as agreed to by the lessor and the lessee. However, a lease is typically for an amount of time that is less than the useful life of the object being leased.

Benefits

A lease can provide several benefits to both lessor and lessee. The lessee gets needed equipment without having to buy it. This means that there is no need to dispose of the equipment at the end of its life. Additionally, in some cases, the payments may be written off directly instead of depreciating the asset at a slower rate. The cost may also be less than buying the asset particularly if the business plans to get a new one before the useful life of the asset ends. For the lessor, the lease provides a way to earn money on capital via an interest rate that is added to the amount necessary to cover the costs. Since the leased property belongs to the lessor, the "collateral" cannot be lost due to court action such as bankruptcy.

Size

A financial lease is generally structured to be amortized, or fully paid off, over the term of the lease. The total amount to be amortized is calculated as the cost of acquisition, plus the depreciation in value of the equipment over the life of the lease, plus an interest rate that represents the profit or return on investment for the lessor.

Considerations

A lease may cost significantly less than buying the asset, particularly if the asset holds its value relatively well (lower cost for depreciation). So, it may be a good option for companies interested in maximizing cash flow. Additionally, the asset may be upgraded more frequently since there is no need to dispose of the asset via sale before the end of its useful life.

Warning

Although there are many benefits to a lease, it should be noted that the lease is a specific length contract. The lessor has no obligation to extend the lease should the company wish to continue using the equipment. This is particularly likely if the equipment's value is higher than projected or if interest rates have risen. Either way, the equipment's cost will increase either through higher lease payments, or by requiring the purchase of a new one.

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