Equipment Leasing: What You Need to Know
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Equipment leasing can be an attractive option when buying and maintaining equipment is too big of an expense for your small business. You don’t want to make an investment just for a new version to be released, possibly making the old one obsolete. Leasing can come with low upfront costs and low regular payments, but it can also result in paying more over time than if you paid for the equipment outright.
- What is equipment leasing?
- How does equipment leasing work?
- Equipment lease contract: Rates, terms and conditions
- How to get an equipment lease
- Comparison: Leasing equipment vs. buying equipment
What is equipment leasing?
An equipment lease is a contractual agreement between the owner of the equipment and a lessee who wants to use the equipment for a specific period in exchange for set payments. In some cases, the lease allows the lessee to purchase the equipment at the end of the term with a balloon, or large, payment.
According to the Equipment Leasing and Financing Association, nearly 8 in 10 U.S. companies use some form of financing when acquiring equipment, including leases, loans and lines of credit. Leasing gives business owners access to vehicles, machinery and equipment that they may not be able to afford otherwise.
There are generally two types of equipment leases:
- Capital leases
- Operating leases
Capital leases, which are usually term, typically can’t be canceled by the lessee. Many companies use capital leases to get long-term access to a crucial piece of equipment. For example, a manufacturer might lease a production machine under a capital lease because they’ll use the equipment daily over a number of years. A company with a warehouse might lease forklifts for the same reason.
Many capital leases allow the lessee to purchase the equipment at the end of the term.
While leasing equipment under a capital lease agreement, the lessee is responsible for maintaining the equipment. They’re also required to get insurance to protect the equipment from theft or damage and pay any taxes associated with the equipment.
Operating leases are more like short-term rentals, allowing a company access to equipment for a shorter period than capital leases. The lessee can cancel the lease — with prior notice — and return the equipment before the term is up. In an operating lease, the lessor retains ownership of the equipment.
Closed-end vs. open-end leases
Leases can also be categorized as closed-end or open-end leases:
- Closed-end lease: The lessee is responsible for maintaining the equipment while it’s in their possession, but they can return the equipment at the end of the lease term without any further obligation.
- Open-end lease: The lessee is responsible for paying the lessor for any loss in value of the equipment while it was in their possession. This can be risky if the equipment becomes obsolete quickly.
How does equipment leasing work?
Depending on whether you have a capital lease or operating lease, the lease may function similar to equipment financing or a rental agreement. Either way, you pay fees in exchange for using the asset.
With machinery leasing or business equipment leasing — or even if you’re leasing IT equipment — your business doesn’t have to tie up a lot of cash into purchasing an asset. You also won’t have to spend time trying to find a buyer once you no longer need the asset. Those risks and responsibilities fall on the company that owns the equipment.
Nearly any type of machinery or business equipment can be leased, so the options and terms of lease agreements can vary. The equipment you lease might be new or used. You may lease the equipment or machinery for years, months, weeks or just a few days. At the end of the lease term, you may have to return the equipment, or you might have the option to purchase it.
Equipment lease contract: Rates, terms and conditions
Equipment lease rates and terms will vary by contract, but here are some general details.
Equipment lease rates for a two- to five-year contract typically range from 8.5% to 20%. These generally fixed rates will depend on:
- Your credit
- The type of equipment you lease
- The business’s industry
Other costs of leasing
Before signing a lease agreement, be sure to review all paperwork thoroughly so you understand the total cost. Some lease agreements offer lower equipment lease rates but make up for it in fees or require the lessee to cover taxes and insurance costs.
Here are some fees you may face.
- Origination fees: These are designed to cover the upfront costs of approving your lease, including reviewing your credit and handling the paperwork.
- Interim rent: This can be charged by lessors for the time between when the equipment is installed and when the first lease payment is made.
- Insurance: Some lease agreements build the cost of insurance into the lease, some charge a separate fee and some require the lessee to provide that they’re carrying insurance coverage for the equipment. Make sure you know who’s responsible for paying to insure the equipment.
- Late fees: These can be charged by the lessor if you’re late on a lease payment. Typical ranges are from 1.5% to 15% of the amount due.
- State or local taxes or fees: Many state and local governments also impose a tangible personal property tax on business equipment, machinery and furniture. Depending on the type of lease, the lessee may be responsible for paying taxes on the equipment. Some state and local governments assess other taxes and fees on equipment leases.
The duration of the lease depends on your needs and the cost of the equipment. It can be short term or long term.
- Short-term leases could be preferable for companies with changing needs or equipment that becomes obsolete quickly.
- Long-term leases could be more convenient and affordable for costly equipment that’s designed to be used for decades.
Some leases may include provisions for early termination or renewal.
The equipment lease agreement will specify your payments and when they’re due. The contract may also specify how the payment should be made — whether that’s via check, wire transfer or autopay — and what happens if the lessee doesn’t pay on time.
Some leases also require a security deposit, which could cover potential damage to the equipment during the lease. However, if damage to the equipment is greater than the security deposit amount, the lessee may be liable for the difference. The security deposit may also help offset the lessor’s costs if the lessee doesn’t make the agreed-upon payments and the lessor has to repossess the equipment. The lease agreement should spell out how the security deposit can be used.
When the lease involves expensive equipment, the agreement might disclose the market value of the machine. This helps the lessee determine the level of insurance coverage for the equipment.
The agreement will lay out the procedures for canceling the lease before the term has ended. Depending on the type of lease, this may involve giving the lessor proper notice or paying an early termination penalty.
How to get an equipment lease
If business equipment leasing is the right move for you, here’s how to get started.
Step 1: Determine your budget
Leasing usually offers lower monthly payments and lower upfront costs than business equipment financing. However, you still need to factor those costs into your budget. Start by figuring out what you can afford to pay upfront — and per payment — and go from there.
Step 2: Figure out how long you’ll use the equipment
Will you need a long-term or short-term lease? That depends on the type of equipment you need and whether that type of machinery or equipment becomes obsolete quickly.
Step 3: Make sure you qualify
Leasing companies look at various factors when evaluating a machinery leasing application, including:
- Length of time in business: Companies that have been in business for two or more years may have an easier time getting approved than startups.
- Credit scores: Leasing companies may look at the business’s credit score, as well as the business owner’s personal credit score. Each business equipment financing company sets its own standards for minimum credit scores. If the owner’s credit score is below 600, the company will have a tougher time getting approval.
- Cash flow and profitability: If you don’t have a strong credit score, you may still qualify for a lease based on your company’s financial performance. The leasing company or vendor may want to review your company’s most recent financial statements, tax returns and other financial documents.
Step 4: Gather other required documentation
The documentation required for a machinery lease varies depending on the value of the equipment and other circumstances of the transaction, but you may need to provide:
- A completed lease application
- A description of the purpose of the lease or how the equipment will be used
- A written business plan
- Pro forma financial statements
- Resumes of the business owners
Comparison: Leasing equipment vs. buying equipment
Best for companies that …
- Have short term-equipment needs
- Use technology that becomes obsolete quickly
- Are tight on cash
|May come with no down payment or low upfront costs||Incurs costs without building equity in equipment|
|Stay up to date with technology||Must coordinate repairs with leasing company|
|May be able to deduct lease payments or depreciate leased property to reduce taxable income||May be locked into lease for piece of equipment no longer needed|
|Lower maintenance costs|
|Lower periodic payments|
Buying business equipment
Best for companies that …
- Don’t plan on keeping the equipment for a long time
- Have a healthy cash flow
|Own equipment||Responsible for repairs and maintenance|
|Can sell asset if no longer needed||Might have to come up with sizable down payment|
|After paying off loan, may be able to use equipment for years without making monthly payments||If equipment becomes outdated, may be tough to find buyer|
|Can benefit from tax deductions, such as Section 179 deduction or bonus depreciation||If financing purchase of equipment that becomes inoperable, still responsible for making loan payments|
When it comes to deciding between leasing business equipment or buying business equipment, consider the particular piece of equipment you need, how long you plan on using it and your financial position.
If you’re short on cash and will only use the equipment for a short time, there are many advantages of leasing equipment. On the other hand, if you’re in a strong cash position and plan on using the equipment for a long time, buying the equipment might be more cost-effective than leasing.