Finance or operating lease? Deciphering the legalese of equipment finance

April 04, 2024

What type of lease makes the most sense for financing equipment? Learn the legal language behind each major financing path and the common pitfalls to avoid.

New equipment is essential for the long-term success of a business, and the decisions around financing that equipment require many considerations. After all, there are two very different lease structures available for equipment financing: finance leases and operating leases. Each type brings its own set of benefits and conditions depending on various circumstances – like the duration of the lease or value of the property. But each path also comes with its own legal terminology to understand and pitfalls to avoid, making the initial decision to finance an equipment refresh the first of many complex choices.

This article will decipher the nuances of the equipment financing process by outlining the characteristics of each lease type, identifying when each one is appropriate, and explaining the four most common pitfalls so your organization can choose the most suitable option and avoid running into problems down the line.

Finance leases

Finance leases meet one or more of the following criteria and are classified as purchases by the lessee:

The lease term is greater than 75 percent of the property’s estimated economic life.
The lease contains an option to purchase the property for less than fair market value.
Ownership of the property is transferred to the lessee at the end of the lease term.
The present value of the lease payments exceeds 90 percent of the fair market value of the property.

Note: This type of lease was also called a “Capital Lease” in the past. Under ASC-842 rule changes, the term “Capital Lease” is no longer used in the GAAP accounting classifications.

Operating leases

Operating leases are any leases that are not finance leases. Organizations generally use them for short-term equipment leasing. The lessee can acquire the use of equipment for just a fraction of the useful life of the asset, and the lessor may provide additional services such as maintenance and insurance.

Why would I choose an operating lease?	What do I need to know before signing an operating lease?
If you do not want to own your equipment or are simply looking for a short-term “right-to-use” agreement, then an operating lease might make more sense.	Since you don’t own the equipment, you wouldn’t get tax depreciation benefits from asset ownership.
Life cycle management. Operating leases allow for more flexibility in upgrading or replacing equipment, especially to keep pace with a 3-5 year lifespan.	Lessors might offer an early buyout option and/or a fair market value purchase option at the end of the lease.
Operating lease accounting processes may be simpler, since lease payments are considered operating expenses.	Lessors may offer lease renewal options– and when you enter into an operating lease, your company may have the option of returning the equipment without further obligation.

Why would I choose an operating lease?

What do I need to know before signing an operating lease?

If you do not want to own your equipment or are simply looking for a short-term “right-to-use” agreement, then an operating lease might make more sense.

Since you don’t own the equipment, you wouldn’t get tax depreciation benefits from asset ownership.

Life cycle management. Operating leases allow for more flexibility in upgrading or replacing equipment, especially to keep pace with a 3-5 year lifespan.

Lessors might offer an early buyout option and/or a fair market value purchase option at the end of the lease.

Operating lease accounting processes may be simpler, since lease payments are considered operating expenses.

Lessors may offer lease renewal options– and when you enter into an operating lease, your company may have the option of returning the equipment without further obligation.

Common pitfalls to avoid in the equipment financing process

Whether you pursue a finance or operating lease, there are several potential pitfalls that can be found in equipment lease contracts that might make things difficult for an organization down the line.

Here are the four most common situations to avoid.

1. Vague end-of-lease term options

Everything in your leasing contract might look good at the start, but some funding sources might try to hide lessor preferential terms in the end-of-lease section. This could greatly cost your organization at the end of your lease, when your equipment is approaching its warrantied lifespan.

Address this concern by making sure that your end-of-term options in the proposal match those in the lease agreement and riders. Also ensure that, if desired, your company has the ability to return the equipment without further obligation at the end of the lease term.

You don’t want to be stuck with outdated technology – it would negate one of the largest benefits of leasing.

2. Artificially low base rates

Those zero percent financing offers may sound tempting, but it generally just means you’ll end up paying more over the long term. If it sounds too good to be true, look into the terms and find out where your vendor is basing those rates.

Zero percent financing from a vendor finance source may reflect an inflated asset cost.

Clients can reconcile true costs by offering to pay with cash and use that sales price as the basis on which the finance rate will be based.

3. Software partners who don’t offer 100 percent financing options

Make sure that the financing source is willing to finance 100% of the asset value. One of the common benefits of leasing in comparison to other forms of financing like bank debt is the ability to finance 100% of the asset cost.

4. Those hidden, unspecified fees

Hidden fees buried in financing documents can trip up organizations, especially near the end of negotiations. Under the guise of “transaction fees” or something similar, these surcharges add to the total cost of leasing.

Some other common fees include:

Documentation
Executory
Commitment
Restocking
Uniform Commercial Code (UCC) filing
Legal
Transactional
Service charges
Facility charges

These potential pitfalls found during the process of signing financing contract can be costly and add to the implicit borrowing cost. It's in your interest to address them before you sign anything.

Choosing the right type of lease is vital to achieving your short-term and long-term business goals — and we can help you decipher the common phrasing used in equipment financing documents. Wherever you are in the discussion, we’re here to help you get the most effective solution.

Contact a U.S. Bank Equipment Finance specialist to discuss your unique situation.