In 2013 I ran the New York marathon for a charity that provides free financial education to the Mexican community living in New York. The director of this charity told us of a heart-breaking story of a middle-aged Mexican immigrant living in New York who always wanted to have her own car. She found the car of her dreams and her local bank agreed to finance it. The lady entered into a three-year contract with the bank. However, given her extremely conservative approach to finance, she decided that she would only start driving the car until it was paid off. She parked her newly acquired automobile in the garage for three years and religiously making the monthly payments. As soon as she had made the 36th payment, and was getting ready to take her machine out for a ride, she received a call from the bank who had financed the car asking her when would be a convenient time for them to pick up their car. The Mexican lady was gobsmacked, bewildered, and confused. She then discovered that instead of entering into an installment sale agreement with the bank, she had entered into a lease agreement. So, what is the difference?
Leasing is a practice that allows a person to use the asset for an agreed period of time against payment of lease rentals. At the end of the term, the lessor can sell the asset to a lessee or terminate/extend the agreement as per mutual consent. In an installment sale, the ownership transfers to the user at the end of the installment period. Whereas in the case of lease financing, the lessee has to transfer the asset to the lessor after the end of the lease period and the lessee has an option to purchase or not to purchase the asset.
The debate between whether it is better to enter into an installment sale or lease agreement on assets is an old one. The objective of this blog is not to put leasing and installment sales into the ring and having them slug it out until there is only one standing. Instead, we want to focus on all that you need to know before you go down the path of leasing heavy equipment.
So, what are the benefits of leasing?
Firstly, most lessors do not require that you make a big initial down payment as is sometimes the case with installment sale agreements. Secondly, in the event that your business requires you to continually upgrade to more advanced equipment, leasing could be a good option in that you are not stuck with obsolete equipment. Thirdly, in most cases, the full lease payment is deductible from your taxable income. In the case of the installment sale, only the interest portion of the payment is deductible.
If a lease sounds like a financial contract that you could use in your heavy equipment business, keep reading.
Equipment Leasing vs. Other Financing Options
Leasing is not the only financial option available to you. Loans, lines of credit, and factoring services are popular means of financing large equipment as well. Like an outright purchase, loans provide more ownership of the equipment. With a lease, the lessor holds the title of the equipment and offers you the option to buy it when the lease concludes. A loan means that you own the asset from day one and are able to depreciate. The biggest downside of a loan is the fixed terms that can be disadvantageous. Typically, on the lease agreement, the interest rate is fixed which provides payments that are fixed throughout the life of the agreement. Loans and lines of credit on the other hand tend to boast variable rates that can make it difficult from a budgeting point of view.
Factoring is another way to fund the purchase of heavy equipment. Factoring is when a business sells its accounts receivable for an upfront payment. For example, your clients owe you R1 million payable over the next 3 months. Your factoring counterparty offers to pay you 90% of this amount (R900,000) today and you then cede the collection rights of this R1 million to the factoring company. This R900,000 is paid to you in cash and you are free to use that cash as you please – such as in the acquisition of heavy equipment. Factoring is also known as invoice discounting.
The Leasing Process: What to Expect
When applying for a lease, you can expect the process to include the following steps.
Step 1: You will need to complete an equipment lease application. Be sure you have financial data available for your company and its principals, as this may be required upfront or after initially completing the application.
Step 2: The lessor processes your application and notifies you of the result. This usually happens within 3 to 5 days. Some lessors may not require financials and/or a business plan.
Step 3: Once you receive approval, you must review and finalize the lease structure, including monthly payments and the fixed interest rate. You'll then sign the documents and resubmit them to the lessor, typically along with the first payment.
Step 4: When the lessor has received and accepted the signed documents and first payment, you are notified that the lease is in effect and that you are free to accept delivery of the equipment and commence any training necessary.
Step 5: Funds are released to you or the manufacturer you are purchasing from.
The Difference between an Operating Lease and a Finance/Capital Lease
Operating Lease
As the name suggests, an operating lease provides operational use of the asset to the lessee. The term structure of the lease is typically shorter than the economic life of the asset. When the lease comes to an end, the asset is returned to the lessor who can then on-sell the asset at its discretion. The typical lease period is between 12 and 36 months.
Finance Lease or Capital Lease
With a capital lease, the lessee may choose to purchase the asset at the end of the lease agreement. Capital lease term tends to be longer – up to 6 years.
Regardless of the lease structure that you select, it is important to understand the responsibilities of the lessee. You need to insure and maintain the machinery.
Lease Counterparties
There are numerous intermediaries that participate in the lease market and it is important to understand the role that each one plays.
Lease broker
The broker acts as an intermediary between you and the lessor. They, in theory, add value by getting the best deal for you by tapping into their network of lessors. They will also handle the paperwork and will haggle with the lessor on terms and interest rates. Normally, this service does not come cheap. They can change between 2 and 4% of the value of the machine being leased. You need to weigh up whether this fee is in line with the quality of the service offered.
Leasing Company
Most OEM’s have their own in-house finance arms that provide leasing services to customers. Given that the OEM is making money on the machine and the lease, they are in a position to offer competitive deal terms.
Independent Lessor
These lessors are not tied to the manufacturer and include banks, lease specialists, and diversified financial companies.
Tips on Choosing a Lessor
Find a lessor that will tailor every aspect of the agreement to suit your needs, allowing you to plan ahead with confidence and budget precision. In addition, we are product and vendor-independent so you can choose any brand of equipment you want, from your preferred supplier, at your best price.
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