As the person in charge of finances at your company, you probably already know that the way you finance an expensive piece of equipment can cost or save your company money, but are you aware of how much and exactly what to look for when making your final determination? Whether you acquire equipment by purchasing or leasing, each has its own unique characteristics and using the best structure for your situation can have a significant impact to your bottom line and cash flow. These are some of the basic differences you should consider between the two options as you orchestrate your strategy.
Down payment
Traditional terms loans will typically require a down payment with a minimum of 20 percent of the equipment costs, while leases can be more flexible to finance up to 100 percent of the cost of the equipment, installation and taxes. Of course, the higher balance will increase the size of the monthly payments, but the low down payment will allow you to hold more of your cash.
Payment Structure
There are exceptions, but typically, traditional term loans are designed to gradually reduce the loan principal with every payment. Amortization will be less than the estimated life span of the equipment. Leases, however, can be more flexible with payment plans. For example, by allowing lower payments during the first few months, payments can also be tailored to fit estimated cash flows (smaller payments at first, higher payments towards the end). Actual payment size will also vary depending on your down payment and residual.
Cost
Measuring the cost of the two options can be tricky and one option is not always a better choice than the other given that the lease and loan differ.
What to Look for:
• Loans, Interest rate, down payment required, prepayment penalty and loan fees (origination, processing, etc).
• Leases, Down payment, monthly payment cost versus purchase at maturity, lease fees (origination, processing, etc).
You'll want a breakdown of estimated costs from your lender to compare the two options; there is no cookie cutter best option. Also, consider the opportunity cost of a larger down payment and your potential need of that cash.
Capitalization vs. Expense
Generally, when purchasing through loans, the principal portion of a purchase is capitalized and offset by gradual equipment depreciation over estimated life span or Section 179 (potentially 100 percent depreciation in one year) and interest is expensed. Section 179 could be used to offset an estimated large tax bill due to high income in one given year. Tax Leases can allow you to expense the whole lease payments (essentially both principal and interest portion), reducing your taxable income over the life of the payments. Consult your CPA for your specific tax implication.
Residual
Residuals are applicable to leases only, equipment loans are generally fully amortized with no balloon payments at the end. An example of residual: A machine costs $500,000 and is financed through a $400,000 lease for 5 years. At maturity, the residual (the portion of cost that has not been paid) would be $100,000.
Although having a payment of a residual at the end of a lease might be discouraging, it may have its advantages. First, you have benefited from using the equipment for only a portion of the cost to purchase. If you decide to purchase, the purchase price will be based on the estimated market value of the equipment at the end the lease. Secondly, you benefit from not having an initial down payment, so your cash position was not impacted when the equipment was acquired. Lastly, after use of the equipment you may or may not want to purchase it outright. End of lease options can be pre-determined for the benefit of the customer. The residual can also be financed and spread out over another 12-18 months.
Have a plan
Consider the overall plan. Not all purchases qualify for either loan or lease financing. Typically, large equipment can be financed, while smaller, easy to carry items or supplies, are excluded. However, you may be able to finance some of the smaller items if you purchase them as a bundle with the larger equipment. So plan your purchase.
These are some of the basic differences between equipment purchases and leases. Opting for one over the other will have implications to your monthly cash flow, cash position, and taxes, so you may also want to consult your CPA and banker. A good relationship banker should be able to offer insight and a number of options.
Contact Schempp at [email protected].
Down payment
Traditional terms loans will typically require a down payment with a minimum of 20 percent of the equipment costs, while leases can be more flexible to finance up to 100 percent of the cost of the equipment, installation and taxes. Of course, the higher balance will increase the size of the monthly payments, but the low down payment will allow you to hold more of your cash.
Payment Structure
There are exceptions, but typically, traditional term loans are designed to gradually reduce the loan principal with every payment. Amortization will be less than the estimated life span of the equipment. Leases, however, can be more flexible with payment plans. For example, by allowing lower payments during the first few months, payments can also be tailored to fit estimated cash flows (smaller payments at first, higher payments towards the end). Actual payment size will also vary depending on your down payment and residual.
Cost
Measuring the cost of the two options can be tricky and one option is not always a better choice than the other given that the lease and loan differ.
What to Look for:
• Loans, Interest rate, down payment required, prepayment penalty and loan fees (origination, processing, etc).
• Leases, Down payment, monthly payment cost versus purchase at maturity, lease fees (origination, processing, etc).
You'll want a breakdown of estimated costs from your lender to compare the two options; there is no cookie cutter best option. Also, consider the opportunity cost of a larger down payment and your potential need of that cash.
Capitalization vs. Expense
Generally, when purchasing through loans, the principal portion of a purchase is capitalized and offset by gradual equipment depreciation over estimated life span or Section 179 (potentially 100 percent depreciation in one year) and interest is expensed. Section 179 could be used to offset an estimated large tax bill due to high income in one given year. Tax Leases can allow you to expense the whole lease payments (essentially both principal and interest portion), reducing your taxable income over the life of the payments. Consult your CPA for your specific tax implication.
Residual
Residuals are applicable to leases only, equipment loans are generally fully amortized with no balloon payments at the end. An example of residual: A machine costs $500,000 and is financed through a $400,000 lease for 5 years. At maturity, the residual (the portion of cost that has not been paid) would be $100,000.
Although having a payment of a residual at the end of a lease might be discouraging, it may have its advantages. First, you have benefited from using the equipment for only a portion of the cost to purchase. If you decide to purchase, the purchase price will be based on the estimated market value of the equipment at the end the lease. Secondly, you benefit from not having an initial down payment, so your cash position was not impacted when the equipment was acquired. Lastly, after use of the equipment you may or may not want to purchase it outright. End of lease options can be pre-determined for the benefit of the customer. The residual can also be financed and spread out over another 12-18 months.
Have a plan
Consider the overall plan. Not all purchases qualify for either loan or lease financing. Typically, large equipment can be financed, while smaller, easy to carry items or supplies, are excluded. However, you may be able to finance some of the smaller items if you purchase them as a bundle with the larger equipment. So plan your purchase.
These are some of the basic differences between equipment purchases and leases. Opting for one over the other will have implications to your monthly cash flow, cash position, and taxes, so you may also want to consult your CPA and banker. A good relationship banker should be able to offer insight and a number of options.
Contact Schempp at [email protected].