Which is better, a lease or a loan? This is a question that comes up all the time, and frankly, one isn’t 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 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 has title to the equipment, while under a lease, 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 purchase 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 purchase options at the end of the term. 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 agreement.

From an accounting standpoint, equipment purchased 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 rather 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 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 your equipment.

Interest rate

At face value, the implicit interest on a loan will be less than that on a lease. In fact, the loan rates provided by the 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 generally provide 100% financing and only require the first payment or the first and last payments at the beginning of the contract. An exception to this may be where a company’s financial standing is marginal, a leasing company may require a down payment to perform 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, often referred to as the 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 preserve its conventional lines of credit and, in effect, create a new line of credit.

restrictive covenants

Most bank loans have many restrictions and covenants, such as maintenance of certain financial ratios, restrictions on future debt, and salary restrictions. Also, look for “call” provisions built into banks 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 General Security Agreement, giving you a security interest on all assets of the company, both those you currently own and those you acquire in the future. This restricts our assets, including inventory and accounts receivable, and may inhibit dealings with vendors and other financial institutions. In the case of a leased property, the lessee presents 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 are 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 written 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 dramatically speeds up your 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 lease agreement. Every situation is different, so proper analysis should be done before making a decision.