Equipment Leasing – The Ultimate Guide

Equipment leases are generally categorized into two groups, operating leases or capital leases, which are structured similarly to a loan. This article will explain the differences between the main types of equipment leasing and help you decide which type of equipment lease might be best for your small business.

If you’re looking for an equipment lease for new or used equipment, the team at Smarter Finance USA is ready to help. If you have a credit score of 600+ and have 5% for a down payment, you can apply for a low rate loan of up to $250K.

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Types of Equipment Leases

Equipment leases have many different names, but your options typically fall under two broad types:

1. Capital Lease: In a capital lease, your business receives all benefits and drawbacks of owning the equipment. All assets and liabilities of the equipment are placed on your business’s balance sheet. Used for equipment you plan to purchase at the end of the lease period. Examples of capital leases include the $1 buyout lease and 10% option lease.
2. Operating Lease: An operating lease leaves equipment off your balance sheet. On paper, your lender owns the equipment and gets to take advantage of any depreciation. Typically best when financing equipment with a short shelf life, or equipment you plan on replacing at the end of the lease.  An example of an operating lease is a fair market value lease.

Within each broad type of lease, there are equipment leases with key distinctions that make them their own unique financing tool. After all, equipment leasing companies know there’s no one-size-fits-all solution. In the table below we provide an overview of the most common equipment leases.

5 Types of Equipment Leases

We recommend speaking with a CPA or tax professional about these options before you make your decision.

Equipment Leasing vs. Equipment Loan

When you buy equipment and finance it with a loan, you own the equipment. The loan just allows you to spread out the purchase price of the equipment over several years. You pay back the principal plus interest over the term of the loan. Plus, in most cases, if you pay off the loan early, you will reduce the amount you pay in interest (there’s no prepayment penalty).

Many people refer to an equipment loan as a finance agreement, which operates just like a capital lease. They generally operate the same way on your business’s books in the way you account for the ownership and depreciation of the equipment.

In contrast, an equipment lease is a long-term arrangement to rent equipment. Technically, you don’t own the equipment when you lease it. However, in many cases leases are virtually indistinguishable from loans except that you don’t save on interest by paying off the lease early. With an equipment lease, you haven’t agreed to pay off a principal plus interest – you’ve actually agreed to a certain number of monthly payments.

According to Chet Zeken, CLFP, President at Smarter Finance USA, “You may want an equipment lease over a loan if you need to upgrade your equipment at the end of the financing term or if you don’t want the depreciation on your books. It could also benefit you if you’re wanting your books to look better to get additional financing or to potentially sell your business, because the debt won’t show up on the balance sheet.”

Smarter Finance USA is a provider that can structure your equipment financing as a lease or a loan. If you have a credit score above 600 and a down payment of 5%, you may qualify for up to $250k in low-rate equipment financing.

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Types of Equipment Leases – In Depth Overview

Before we look at each type of individual lease in more detail, it’s important to understand when to use a capital lease versus when to use an operating lease.

When to Use a Capital Lease

A capital lease is used much more often than operating leases are. Typically if you’re purchasing large pieces of equipment that you’ll want to keep as a long term asset, then a capital lease is the best option for you. If you’re wanting to take advantage of the benefits of owning your equipment, like claiming the depreciation of it, then an operating lease won’t work for you.

When to Use an Operating Lease

An operating lease is typically the right option if you’re wanting to replace your equipment at the end of your financing term. It may also be right for you if you’re acquiring equipment that has a very short term shelf life, like technology, or if you’re unsure of whether or not you’ll need the equipment long term.

Now that you have a good idea of which type of generic lease you need, let’s look at each type of individual lease in more detail.

What is a $1 Buyout Lease?

A $1 buyout lease is a capital lease where you make monthly rental payments to access and use the equipment, but at the end of the lease, you have the option to buy the equipment for $1. Since you get to buy the equipment for just $1, the characteristics of this type of lease are similar to a loan, with higher monthly payments than an operating lease.

For all intents and purposes, you’re treated like the owner of the equipment when you have a $1 buyout lease. For example, if you lease a $10,000 pizza oven on a $1 buyout basis, the oven will appear as an asset on your business’s balance sheet, and the lease will appear as a corresponding liability.

For tax purposes, using Section 179, it is possible to deduct the entire $10,000 as a business expense in the first year of purchase. This can save you money on your tax bill. However, we are not a tax advisor, and for tax questions related to your business, we recommend that you ask a tax professional.

When Should I Use a $1 Buyout Lease?

You should use a $1 buyout lease when you know you want to own the equipment after the lease is over. If the equipment has a long shelf life and doesn’t lose a lot of value over time, it’s more economical to do a capital lease like this one. The $1 buyout lease will have higher monthly payments than other capital leases, but the payout at the end is the lowest.

Some examples of equipment that may work with a $1 buyout lease are durable items like tractors, refrigerators, and ovens that tend to retain their value over time. Remember, since a $1 buyout lease shows up on your balance sheet as a liability, it gets incorporated into calculations of your overall debt and can hurt your ability to qualify for other loans.

What is a 10% Option Lease?

A 10% option lease is a capital lease that gives you the benefit of owning the equipment throughout your lease term, with an option to fully purchase the equipment for 10% of its cost. For example, if you lease an x-ray machine worth $20,000, you’ll pay $2,000 to own it at the end of your term.

Like the $1 buyout, this lease treats the business like the owner of the equipment. The equipment and the lease will appear on your balance sheet. You may be able to deduct the full cost of the equipment in the first year of purchase on your federal tax return, using Section 179.

When Should I Use a 10% Option Lease?

One reason that many small businesses choose a 10% option lease over a $1 buyout is because the 10% option lease offers a smaller monthly payment.

For example, let’s assume you’re leasing equipment worth $100,000 for 5 years. Here’s what the monthly payments and cost to purchase the equipment at the end of the lease (aka the bargain payment) would be for a $1 buyout and 10% option lease:

• $1 Buyout Lease: $9,999 leased + $ 1 purchase option at end =  $833 monthly lease payment (monthly payment are based on the amount leased)
• 10% Option Lease: $9,000 leased + $1000 purchase option at end = $750 monthly lease payment

As you can see, your monthly payment would be $83 lower on the 10% option lease, but at the end, you have to pay $1000 to own the medical equipment. So the tradeoff is that with a 10% option lease, you pay less throughout the term of the loan, but more at the end. Your business’s finances and cash flow will most likely determine which is a better choice for you.

Smarter Finance USA is a direct lender specializing in equipment lending. They will work with you to find the best financing option for your business. Borrowers can qualify for up $250K in funding with as little as 5% down. See if you qualify today.

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What is a Fair Market Value Lease?

A fair market value (FMV) a lease where you make monthly rental payments in exchange for the right to access and use the equipment. At the end of the lease, you typically have the option to purchase the equipment at its fair market value (as determined by the leasing company), renew the lease, or return the equipment.

A FMV lease is an operating lease, which means it doesn’t offer the benefits or responsibilities of ownership to the small business. You’re not considered the owner of the equipment, and the equipment doesn’t show up as a business asset on your balance sheet. Since you’re not the owner, you cannot deduct the entire purchase price of the equipment on your federal tax return. You can only deduct the monthly lease payments as a business expense.

When Should I Use a FMV Lease?

An FMV lease is ideal for software and technology products, or other equipment that quickly becomes obsolete. This is because you won’t be stuck figuring out how to dispose of the equipment at the end of the lease. For example, you can use an FMV lease to get computers for your employees. At the end of the lease, you can return the computers to the leasing company and upgrade to newer and better ones. If you have an equipment loan or another type of lease, you may be stuck with an out-of-date computer which you then have to sell or get rid of.

The other case where it makes sense to use an FMV lease is when you’re trying to conserve your business’s cash flow. A FMV lease usually offers lower monthly payments. In addition, an FMV lease stays off your business balance sheet, so it doesn’t add to your overall debt level. This can make it easier to get another business loan, or make your books look better if you’re preparing to sell your business.

Unfortunately, it’s not that easy for small businesses to qualify for a FMV lease, especially for equipment under $150,000. Since a FMV lease offers lower monthly payments, it places more risk on the equipment leasing company. You’ll typically need a higher credit score and better credit profile then you would with any of the other lease types.

What is a 10% PUT Lease?

The “PUT” in “PUT Lease” stands for purchase upon termination. This lease operates exactly like the 10% option lease with one large exception. You must buy the equipment at the end of the term instead of it being an option for you.

Everything else about the lease operates exactly the same as described above.

When Should I Use a 10% PUT Lease?

If you know for sure that you’re going to buy the equipment at the end of the financing term, and that you’ll have the 10% cost to do so, then this could be the right option for you. You may be able to get a lower monthly payment with this lease over the 10% option lease because the lender knows you’re buying the equipment at the end of the term and there is much less risk in them getting stuck with it.

Depending on the size and cost of your equipment, 10% of the cost may be an expensive payment for you to make. If it is a large payment to you, and your cash flow is unpredictable, then you may want to consider using the 10% Option Lease instead.

What Is a TRAC Lease?

A terminal rental adjustment clause lease, or TRAC lease, can be a capital lease or an operating lease, but it is only for the acquisition or use of vehicles, like semi trucks. With a TRAC lease, the future purchase price, if any, is known at the time you sign the lease, and your monthly payment is based off of that price.

There is a lot of flexibility with a TRAC lease because of it’s ability to be written as either a capital or operating lease. It can give you the room to negotiate your purchase price based on what you think the vehicle will be worth at the end of the financing term.

A TRAC lease may be your best option if you’re wanting to pay a larger portion of the equipment at the end of the term instead of as a down payment, or stretched out over the term of your lease agreement. Other options like the 10% PUT lease requires you to pay 10% of the purchase price at the end of the lease term. A TRAC lease, on the other hand, could lower your monthly payments by requiring a larger amount, like 20-25%, of the purchase price to be paid at the end of the term.

When Should I Use a TRAC Lease?

Small business owners can only use a TRAC lease if they’re using it for a commercial vehicle. It may be the right option for you if you want to purchase the equipment but need flexibility in what you pay at the end of financing term. For example, if you’re wanting to pay 25% of the cost at the end of the term then you could do that with a TRAC lease. That would give you lower payments throughout the term, but require a much larger lump sum than the other capital lease options.

In Depth Comparison of Types of Equipment Leases

Equipment financing requires you to consider many different factors. Now that you’re familiar with each type of lease, we’re going to go into more detail about the terms and costs of each one.

Equipment Lease Qualifications

In general, it’s not too difficult to get an equipment lease because the lease is backed by the equipment. We interviewed Gerry Egan, executive director of the National Equipment Finance Association, for this article. He said that the approval decision will primarily depend on a combination of five factors:

1. Your credit score (660+  on average, check yours for free here)
2. Business history
3. Type of lease and size of lease
4. Length of the lease
5. How well equipment holds value

Most lenders will evaluate credit history, and ideally, you should have a credit score over 660. If you fall below that, you may still be able to get an equipment lease, but you’ll likely have to pay a higher interest rate. You can check your credit score for free with Nav. In most cases, you need at least 2 years in business to qualify for an equipment lease. Newer businesses can qualify, but only if they have a great credit score, and they should be prepared to pay an interest rate on the high end.

In general, the more valuable the equipment you’re trying to finance and the longer the lease term you’re committing to, the more attractive the deal is to equipment financing companies. Well qualified borrowers will find themselves qualifying for more equipment leasing options and at better rates the larger their deal is.

Here’s how the different types of leases stack up in terms of how easy it is to qualify:

$1 Buyout Lease

It would be easiest to qualify for a $1 buyout lease. This is because you end up paying all but $1 of the equipment’s value over the term of the lease. In other words, by the end of the lease, the equipment financing company has been fully compensated for the equipment.

10% Option Lease

It’s also pretty easy to qualify for a 10% option lease because you pay 90 % of the equipment’s value during the term of the lease.

FMV Lease

FMV leases are hardest to qualify for. The monthly payments are significantly lower, so the equipment leasing company isn’t fully compensated for your use of the equipment by the end of the lease. As a result, FMV leases are easier to obtain when you have a good credit score (over 630-650) and are leasing expensive equipment (over $150,000 is a good ballpark). According to Mark French, CEO of equipment finance company Crest Capital, FMV leases are only possible when the equipment is expensive enough to make the leasing company’s handling costs worthwhile. In other words, the leasing company must feel that it is “worth it” to spend the time and effort needed to find a new buyer/renter for the equipment after a lease ends.
If you lease equipment that retains its value over a long period of time, then you may be able to qualify for an FMV lease. Equipment like construction cranes tend to lose very little value over several years. In such cases, the equipment leasing company will be more willing to take a credit risk because they can easily sell the crane at the end of the lease or lease it to someone else.

10% PUT Lease

Just like the 10% option lease, you’re paying 90% of the equipment value through your monthly payments throughout the financing term. That makes this type of lease fairly easy to qualify for, with even bad credit being a possibility.

TRAC Lease

It depends on what type of TRAC lease you’re building, and what type of purchase price you negotiate. These leases will typically go to better qualified borrowers because of the flexibility and potential for lower monthly payments. This is not one of the easier lease types mentioned in this article to qualify for, and it’s required that you’re leasing a vehicle.

Equipment Lease Rates, Costs, & Terms

A lease is not a loan, so you don’t pay ‘interest’ in the typical sense of the term. However, the equipment leasing company has to make money in some way, and you will obviously have to pay for the right to use the equipment. The effective interest rates on an equipment lease range anywhere from 2-30+ %, but the average is somewhere between 6-16 %. The length of the lease will typically range from 2-5 years, not to exceed the useful life of the equipment.

The cost of leasing will depend primarily on the same 5 factors that are used to make the credit decision:

1. Your credit score (660+ on average, check yours for free here)
2. Business history
3. Type of lease and size of lease
4. Length of the lease
5. How well equipment holds value

All other things being equal, the better your credit score is, the lower your cost will be. If you have a credit score less than 660, you can still get an equipment lease, but you can expect to pay a higher interest rate. You can check your credit score for free with Nav.

In addition, the less valuable the equipment (i.e. the smaller the lease), the higher your cost will be. Durable equipment like tractors and construction cranes that tend to retain value will qualify for the best rates.

If you’re a brand new company, you can also expect to pay more. Most equipment leasing companies prefer businesses with at least 2 years history.

Finally, shorter leases typically have a higher cost because you’re not putting the equipment to use for as long a time.

$1 Buyout Lease

The interest rates on a $1 buyout lease will be similar to the interest rate on an equipment loan. Rates typically range between 6-15 %. In actuality, the monthly payments are going to differ only a little from an FMV lease–for example, a $100,000 piece of equipment on a 48 month lease may run you $2457/month on a $1 buyout and $2279/month on a FMV lease.

10% Option Lease

The 10% option lease will have slightly higher interest rates than the $1 buyout lease. Its interest rate ranges from approximately 7-16 %.

FMV Lease

Although the monthly payments are lower on an FMV lease, the long-term cost of an FMV lease will be higher than it is for a $1 buyout or 10 % option lease. You can think of this as the difference between having a home mortgage and renting a home. Owning a home and paying a mortgage works out more cheaply in the long term. Similarly, a $1 buyout lease and 10 % option are cheaper in the long run because you can buy and own the equipment for well under its market value at the end of the lease.

10% PUT Lease

The PUT lease will range from 7-16%, but will typically be slightly less than the 10% option lease.

TRAC Lease

The costs of the TRAC lease vary depending on how the lease is written. The interest rate can vary greatly based on your credit profile and the amount you negotiate to pay off at the end of your term.

All of the leases discussed in this article will also have some startup costs that you should be aware of. A loan may require a down payment or have fees, such as origination fees and application fees. A lease, regardless of the type, will usually require a security deposit equal to one month’s installment and upfront payment of the first month’s installment. Whether you buy or lease equipment, it is the business’ responsibility to insure and maintain the equipment.

Size of Monthly Lease Payments

One of the first things businesses want to know when leasing equipment is the size of their monthly payments. Lowering your monthly payments can increase your business’ cash flow. There are many factors that go into figuring out what your monthly payment is going to be, and it varies by lease.

$1 Buyout Lease

Carries the highest monthly payments because your lease payments are based on 99% the equipment’s cost. Your payments will be similar to what you would expect to pay if you had taken out an equipment loan.

10% Option Lease

Carries higher monthly payments than an FMV lease but lower monthly payments than a $1 buyout lease. Lease payments are based on 90% of the equipment’s cost.

FMV Lease

Offers the lowest monthly payments of all the lease types.

10% PUT Lease

Works just like a 10% option lease, but generally with slightly lower monthly payments.

TRAC Lease

Varies based off of how the lease is written. It could carry lower monthly payments like an FMV lease, or it could offer higher payments like a 10% option lease. Generally, the monthly payments are lower because it either works as an operating lease, or there is a larger lump sum payment at the end.

To learn more about what your monthly payment might be, you can check out our equipment loan calculator.

Equipment Lease Tax Treatment

Tax treatment is one of those areas where the type of lease you choose could end up saving you a lot of money. $1 buyout and 10% option leases are typically much friendlier to your business from a tax standpoint. For questions related to your business, we suggest talking with a tax professional.

$1 Buyout Lease

You can claim ownership under a $1 buyout lease and deduct the entire cost of the equipment on your federal tax return using Section 179 of the federal tax code. The current limit on the amount you can deduct is $500,000. Gerry Egan, executive director of the National Equipment Finance Association, explained that the advantage offered by Section 179 is accelerated depreciation. Instead of taking a partial write off of the equipment each year, you can deduct the entire cost of the equipment (up to $500K) in the year your lease begins.
In many cases, the amount you save in taxes by using Section 179 will exceed the total of your first year’s lease payments. In fact, Mark French of Crest Capital told us that small businesses can save up to 35 % more using Section 179 than they can by deducting monthly lease payments on an FMV lease.

10% Option Lease

As with a $1 buyout lease, a 10 % option lease gives you the option to use Section 179.

FMV Lease

Since you’re not treated as the owner of equipment in a FMV lease, you can’t deduct the entire cost of the equipment on your federal tax return. However, you can deduct the monthly lease payments as a business expense. To qualify as an FMV lease for tax purposes, your lease has to meet criteria set by the IRS, like making sure the term of the financing doesn’t exceed the likely life of the equipment.

10% PUT Lease

A PUT lease also gives you the option of Section 179.

TRAC Lease

A TRAC lease can work either like the PUT lease or the FMV lease, depending on how it is originally written.

Accounting Treatment (Balance Sheet)

In addition to tax treatment, you have to think about how equipment will be treated on your business’ balance sheet. This can affect your business’ ability to get other loans.

$1 Buyout Lease

The equipment will show up as an asset on your balance sheet, and the lease will show up as a corresponding liability. This adds to your overall debt level, possibly making it more difficult to obtain another loan.

10% Option Lease

A 10% option lease will also show up as an asset and liability on your balance sheet, potentially making it harder to get other loans.

FMV Lease

With an operating lease the equipment stays off your balance sheet. If you know that you’ll be needing another loan (e.g. a working capital loan), this is a good thing. By staying off the balance sheet, an FMV lease reduces your overall debt level and makes it easier to obtain another loan.

10% PUT Lease

The PUT lease will show up as an asset and a liability on your balance sheet.

TRAC Lease

A TRAC lease can work either like the PUT lease or the FMV lease, depending on how it is originally written.

Bottom Line

As you can see, there are a lot of considerations that come into play when deciding which type of equipment lease is best for your business. If you need lower monthly payments or are leasing equipment that quickly gets out of date, consider an an operating lease like the FMV lease. If you want to own the equipment or are leasing equipment with a long shelf life, then you should consider a capital lease like the $1 buyout lease or 10% PUT lease.

For APR’s starting at 6%, visit direct lender Smarter Finance USA. With a credit score above 600 and as little as 5% down, your business may qualify for up to $250k in equipment financing.

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Glossary on Equipment Leasing Terms

Capital Lease

A capital lease is a lease that is similar to an equipment loan, and the business is treated as the owner of the equipment. A capital lease is designed for businesses that are fairly certain they want to keep the equipment at the end of the lease.

Operating Lease

An operating lease is a type of lease where the business makes monthly rental payments to access and use equipment, but doesn’t own the equipment. At the end of your lease term, you may have the option to purchase the equipment, but you’d have to pay the full fair market price to do so.

Equipment Financing Agreement

Similar to a $1 buyout lease contract in almost every way, but due to some state laws on taxes and bankruptcy, it is structured like a loan instead of a lease.

Lessee

The renter, typically the small business that rents and uses the equipment.

Lessor

The legal owner of the equipment, usually the equipment leasing company that leases the equipment to you.

Section 179

Provision of the federal tax code that allows accelerated depreciation. Basically, you can depreciate the entire purchase price of the equipment in the first year of financing instead of spreading the depreciation over a number of years. Click here to the current ceiling on how much you can deduct each year.

True Lease

IRS term for a fair market value lease. If it is a true lease, then you can only deduct the monthly lease payments as a business expense. If it not a true lease, then you may be able to depreciate the entire cost of the equipment using Section 179. For specific advice, please ask your tax professional.

Bargain Purchase Option

Language in an equipment lease that gives a lessee the ability to buy the leased equipment at the end of the lease. In most cases the bargain purchase cost will be at lower that current fair market value. Most common in capital leases.