Leasing Vs Loan: Which is better?
What is better, a lease or a loan? This is a question that comes up all the time, and frankly, one is not 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 being said, a loan is often perceived as a method of purchasing equipment and a lease is perceived as a method of paying for the use of the 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 holds title to the equipment, while under a lease agreement, title to the equipment is held by the Lessor, also known as the leasing company.
Many companies have a desire to own equipment and simply want to buy it outright. In reality, if a loan is used to buy a team, they actually hold title to the team; however, they do not actually own the asset until the final payment is made.
In recent years, the term “lease to own” has become very popular, and in fact, many leasing companies offer bargain end-of-term purchase options. When this is the case, the lessee must be cautious in the accounting treatment of the lease, since the Government may interpret it as a loan agreement.
From an accounting standpoint, 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 a debt but as an expense on the income statement. Leasing is often referred to as off-balance sheet financing and, in turn, has a positive effect on some of the financial ratios, such as the debt-to-equity ratio.
Let’s take a look at some of the areas to consider when making the decision to use a loan or lease to finance equipment.
Interest rate
At face value, the implicit interest on a loan will be less than on a lease. In fact, the loan rates provided by banks are lower than 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.
Low pay
Most banking institutions require between 10% and 25% of the cost of the equipment as a down payment. On the other hand, a leasing company will typically provide 100% financing and only require the first or first and last payment at the start of the contract. An exception to this may occur where a company’s financial standing is marginal, a leasing company may require a down payment to lease.
Additional Credit Facility
When evaluating an equipment loan, a bank will generally consider the full amount of outstanding debt owed to a particular customer, often referred to as an exposure. Banks have exposure limits based on the financial size and strength of the organization, as well as its transaction history. Exposure is always factored into your credit decisions. If a loan increases exposure to the upper limit, it may inhibit further use of conventional bank lines of credit for normal operating expenses. By using a third-party leasing company to finance an equipment purchase, a business can retain its conventional lines of credit and actually create a new line of credit.
restrictive covenants
Most bank loans have many restrictions and covenants, such as the maintenance of certain financial ratios, restrictions on future debt, and salary restrictions. Also, look for “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. The lease does not have any of these types of provisions.
General Security Agreement
Depending on a number of factors, a bank will often file a Master Security Agreement, which gives them a security interest in all of the company’s assets, both those it currently owns and any it acquires in the future. This restricts our assets, including inventory and accounts receivable, and may inhibit dealings with suppliers and other financial institutions. In the case of a leased property, the lessee files a document called a Personal Property Security Agreement or PPSA, which gives them an interest in the leased property only.
tax implications
In the case of a loan, the asset is capitalized and included as an asset on the balance sheet. From a tax standpoint, depreciation and interest on the loan is recorded for tax purposes. Assets are classified into classes, and each class has a different allowable depreciation rate. In the first year of the loan, only 50% of the depreciation can be paid off, as well as the interest portion of the loan. In subsequent years, depreciation can be written off on a declining balance basis.
Lease payments, on the other hand, are treated as an expense on the income statement and are typically written off in full. This drastically speeds up the tax deduction and provides a tremendous tax effect over a conventional bank loan.
In summary, there are advantages and disadvantages to financing equipment on both a loan and a lease agreement. Every situation is different, so proper analysis should be done before making a decision.