When businesses need to acquire essential equipment, they often face a critical decision: should they lease the equipment or take out a loan to purchase it? Both options have distinct advantages and drawbacks, and understanding these differences is key to making a sound financial decision. In this blog post, we’ll explore the key differences between equipment leases and loans, outline the basic requirements for starting an application, and address some common misconceptions about these financing methods.
Equipment Loans: What to Expect
When you opt for a loan to finance equipment, you borrow a lump sum from a lender, which you then repay over time with interest. Here are some key aspects of equipment loans:
Taxes Required Upfront
When you take out a loan, the full sales tax on the equipment is usually due at the time of purchase. This means you need to have the cash available upfront to cover these taxes, which can be a significant amount depending on the equipment's cost. There are instances where you can finance the sales tax for a short period of time (often referred to as a balloon period that usually is no longer than 120 days), but ultimately this tax needs to be repaid at the end of the balloon period.
Immediate Ownership
With a loan, you gain immediate ownership of the equipment, as the title is in your name from the start. This offers benefits resulting in a simpler insurance and registration process.
Competitive Interest Rates
Loans often come with competitive interest rates. Depending on your creditworthiness and the loan terms, the interest rate on a loan can sometimes be lower than the implicit interest rate on a lease.
Leasing Equipment: An Overview
Leasing allows businesses to use equipment by making regular payments over a set term. At the end of the lease, you may have the option to purchase the equipment, return it, or renew the lease. Here are some important aspects of leasing:
Taxes Spread Over the Lease Term
Unlike loans, leases typically spread the sales tax across the term of the lease. This means you’ll pay a portion of the sales tax with each monthly payment, easing cash flow pressures.
End-of-Term Purchase Option
Many leases include a buyout option at the end of the term, where you pay a specific amount to transfer the title of the equipment to your business. The buyout can vary in amount and can be a nominal figure like $1.00, or it can be based on the then fair market value of the equipment. Either way, the lease agreement should identify what the buyout option is, so there are no surprises at end of the lease term.
Types of Leases
There are two main types of leases to consider:
Capital Leases: These are similar to loans from an accounting perspective – the lease is recorded on your balance sheet, as both an asset and liability, and at end of term you have an obligation to purchase the equipment.
Operating Leases: These function more like rental agreements, with payments treated as operating expenses. The equipment does not appear on your balance sheet, which can benefit your financial ratios such as leverage and debt servicing.
Leases and Income Tax: It doesn’t matter what type of lease you choose, for income tax purposes you deduct the lease payments incurred for the equipment used in your business. Of course, there are exceptions and limitations to the amount you can deduct, we strongly recommend consulting with your Accountant for specific tax implications.
What You Need to Start an Application
Application-only Submissions (<$500,000)
Complete, sign, and return a credit application.
Provide equipment details and specifications such as (purchase price, year, make, model, hours/odometer readings, seller information and timeframe to purchase).
Full Application or Structured Submissions (>$500,000)
Complete, sign, and return a credit application.
Submit the most recent 3 years of accountant-prepared financial statements for the borrowing entity.
Provide the most recent Year-to-Date Income Statement, Balance Sheet and Accounts Receivable and Accounts Payable summaries for the borrowing entity.
Provide equipment details and specifications such as (purchase price, year, make, model, hours/odometer readings, seller information and timeframe to purchase).
Provide detailed work program information (what are you working / bidding on now and what do you see in the future)
Provide a current debt summary, or “debt stack” that identifies all of your current debt obligations for the borrowing entity (monthly payments, maturity dates, lender names, what is securing the current debt, etc.)
Debunking Common Misconceptions
Misconception: Leases Always Contain Hidden Fees
Reality: There should be no surprises with lease financing, always ensure you request an amortization schedule of lease payments to confirm your understanding of the terms.
Misconception: Leases Offer Easy Early Termination
Reality: Early termination of an equipment lease is often calculated using the balance of payments owed, meaning you will pay the full interest to term despite paying off the lease early. This can make it more costly to exit a lease early compared to paying off a loan.
Misconception: Leases Always Have Higher Interest Rates
Reality: Interest rates on leases can be competitive and, in some cases, lower than the interest rates for equipment loans, depending on the borrower’s credit profile and borrowing terms.
Misconception: Loans Significantly Harm Credit Scores
Reality: Well-managed loans can improve your credit score over time. Consistent, on-time payments demonstrate financial responsibility, which can positively impact your credit history.
Choosing Between an Equipment Lease and a Loan
When deciding between leasing and taking out a loan for equipment financing, consider the following:
Cash Flow: If maintaining cash flow is crucial, leasing might be better, as it often requires lower initial payments and can have extended terms/amortizations.
Ownership and Control: A loan gives you immediate ownership and control, which can be beneficial for tax purposes depending on the time of year you acquire the equipment (speak with you accountant to determine this).
Flexibility: Equipment leases can offer more flexibility with varying end-of-term options, making them ideal for businesses that frequently upgrade equipment, purchase equipment with high obsolescence, or require equipment on a project-by-project basis.
Financial Statements: Consider how each option will affect your balance sheet and speak with your accountant prior to making a decision. Capital leases and loans appear as liabilities on your balance sheet, impacting financial ratios, while operating leases do not, which can be advantageous for bank covenant management and future borrowing capacity.
Conclusion
The choice between leasing and taking out a loan for equipment financing depends on your business's specific needs, financial situation, and long-term goals. By understanding the advantages and disadvantages of each option, you can make a well-informed decision. At Canadian Equipment Finance (CEF), we’re here to help you navigate the complexities of equipment financing and find the solution that best fits your needs. Contact us today to learn more about how we can support your business's growth and success.