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What Are Finance Leases?: A Comprehensive Guide

Written by, Marija Petkova

Updated July, 22, 2022

If you’re looking for a deal that will let you to own a vehicle (or any other equipment you need for your business), without actually buying it, then you might consider getting a finance lease.

But, what are finance leases, how do they work, and what are the pros and cons of getting into this type of deal?

Read on to find out.

What Qualifies as a Finance Lease?

A finance lease, which is also referred to as a capital or a sale lease, is a type of financial agreement, where the user of the asset (lessee) rents it for an agreed period, while the finance company (the lessor) remains the legal owner

Finance leases are most commonly used by companies, self-employed people, and traders for financing commercial vehicles and other equipment they need for business purposes.

How Do Finance Leases Work?

In a finance lease deal, the user (lessee) rents the asset for a certain period – usually for the entirety of its useful economic life–  and takes most of the risks and rewards that come with ownership, but never actually owns the asset.

In practice, this means that a finance lease looks and feels a lot like a hire purchase, but your balance sheet would look different and you won’t take ownership of the asset at the end of the agreement (unless that’s part of the deal). It is essentially a long-term rental.

An example of a finance lease arrangement would be hiring a vehicle for delivery purposes for your business for 3 years and returning it to the company once the agreement ends. (You could also take a finance lease for multiple cars).

Under the finance lease conditions, you will be responsible for maintaining the vehicle, covering repairs, and regular checks, while making rental payments to the finance company. 

How Are Finance Lease Costs Calculated?

The monthly payments are calculated based on the length of the lease, the initial cost of the vehicle, and the overall value. If you opt for a finance lease with a balloon payment,  you’ll have to pay a lump sum at the end of the agreement, but your monthly payments will work out cheaper. 

What Happens At The End of The Finance Lease Deal?

Once the deal ends, also called the primary period, the asset will normally be at the end of its useful life. You then have three options:

  • Return the asset to the finance company.
  • Sell the asset to a third party and keep a share of the income.
  • Continue to use the asset in a secondary period (often with cheaper payments). 

Advantages and Disadvantages Of Finance Leases

A finance lease agreement can be a cost-effective solution for certain situations, but less ideal in other circumstances.

Pros

  • Option for fixed payments.
  • Minimum capital expenditure.
  • VAT registered companies can claim back 50-100% of the VAT (depending on the finance element). 
  • Reduced administration.
  • Flexibility to extend the agreement.
  • Option to benefit from vehicle sale.

Cons

  • Maintenance and repair costs.
  • Interest rates can vary on some contracts.
  • A finance lease is non-cancellable.

Finance Lease vs Operating Lease

There are two types of lease financing: finance lease and operating lease.

The main difference between an operating lease and a finance lease is that with an operating lease, the risk and return stay with the finance company (the lessor).

This means that in an operating lease, the lessor is responsible for maintenance. Also, an operating lease is a short-term concept, unlike a finance lease, which can span over a longer period.

Another major difference is that a finance lease is viewed as ownership rather than a rental and the finance lease will have a significant impact, for accounting purposes, on depreciation expenses, liabilities, and interest expenses, among other things. An operating lease, on the other hand, is classified as a rental agreement.

Bottom Line

A finance lease is an excellent option for businesses that need certain equipment (most commonly vehicles) but don’t want to buy them outright. 

With this type of agreement, you get all the perks and disadvantages of being the owner of the asset and you can rent it for the entirety of its useful economic life.

                           

Frequently Asked Questions And Their Answers

How does a finance lease work?

In a finance lease, the lessee rents an asset for an extended period of time and takes all the responsibilities that come with owning it, while the legal ownership remains with the lessor.

What is the difference between an operating lease and a finance lease?

The difference between the two is that an operating lease is a short-term contract and the lessee doesn’t have any ownership rights or responsibilities.

What are finance leases?

A finance lease is a type of agreement in which the hirer rents the assets and assumes the responsibilities related to maintenance and repair, while the lessor remains the legal owner.

My name is Marija, and I'm a financial writer at DontDisappointMe. Although finance might not be everyone's cup of tea, my 10+ years of working in one of the biggest banks in my country, and my interest in extensive research on everything finance/investment-related, have made me somewhat of an expert in the field (if I do say so myself). No longer having the passion to work in a corporate setting, I decided that I couldn't let all of this knowledge go to waste so I started writing. And, here I am! Today I try to share my knowledge with my audience in the hopes of making this topic as simple and interesting as possible. In my leisure time, I like spending time with my family and travelling to new locations.