Equipment leasing is an agreement that allows a business to gain access to a piece of equipment without buying it. Equipment leases are generally available through manufacturers, dealers, banks, and alternative financing companies. Equipment lease payments are typically 20% to 50% less than equipment loan payments, and many have a balloon payment due at the end.
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 or higher and have 5% for a down payment, you can apply for a low rate loan of up to $250,000.
How Equipment Leasing Works
Leasing grants the business owner access to needed equipment without buying it. Businesses make regular payments in exchange for the use of the equipment. In many cases, leasing equipment allows businesses to upgrade equipment frequently. Other leases have a bargain purchase option that allows ownership of the asset to transfer to the borrower at the end of the term.
There are two types of leases as classified by the Financial Accounting Standards Board (FASB): the capital lease, and the operating lease. A capital lease is any lease with a bargain purchase agreement that transfers ownership to the business owner at the end of the lease. An operating lease grants the business owner temporary use of the equipment, with no transfer of ownership at the end.
Equipment leases typically fall into one of two categories:
- A capital lease is a rental contract in which your business receives all benefits and drawbacks of owning the equipment. A capital lease is more common than an operating lease and is best suited for acquiring expensive pieces of equipment that you intend to keep as a long-term asset.
- An operating lease is a rental contract in which your business does not receive the benefits of ownership. An operating lease is typically used when financing equipment with a short shelf-life, or equipment that you plan to replace frequently or at the end of the lease.
Which lease class you ultimately choose comes down to whether or not your business intends to own the leased equipment at the end of the lease, and whether payments made during the lease make up a majority of the value of the equipment. There are also tax and accounting considerations you will want to be aware of. To learn more about the two classes of lease, read our article on Capital Leases vs Operating Leases.
Equipment Lease Qualifications
In general, it’s not too difficult to get an equipment lease because the equipment backs the lease. 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.
The five factors cited by Egan are:
- Your credit score (660-plus on average, check yours for free)
- Business history
- Type and size of lease
- Length of the lease
- How well equipment holds value
When you apply to lease equipment, your lease rate will vary depending on your credit score. Anything above a 660 is considered a good score. In most cases, you’ll need at least two years in business to qualify. Newer or start-up businesses may still qualify, but an excellent credit score will be required, and the interest rate is likely to be higher.
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 have to pay for the right to use the equipment. Effective interest rates on an equipment lease typically range from 6% to 30%, but the average is somewhere between 6% to 16%. The length of the lease will usually vary from two to five years but won’t exceed the useful life of the equipment.
The cost of leasing will depend primarily on the same five factors that are used to make the credit decision:
- Your credit score (660-plus on average, check yours for free)
- Time in business
- Type and size of lease
- Length of the lease
- How well equipment holds value
Lower credit scores―less than 660―shorter-term leases, and leases on less valuable equipment all tend to be more expensive. Higher-cost equipment and leases to established companies will generally have the lowest leasing costs.
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. Many factors go into figuring out what your monthly payment is going to be, and it varies by lease.
To learn more about what your monthly payment might be, you can check out our equipment loan calculator.
Equipment Lease Tax & Accounting Treatment
Tax treatment is an important factor as different types of leases receive different tax treatment. In addition to tax treatment, you will want to consider how the equipment will be treated on your business’ balance sheet.
Capital leases―also classified as $1 buyout and 10% option leases―are typically much friendlier to your business from a tax standpoint, allowing you to depreciate the asset. This is not possible with most fair market value (FMV) leases, which tend to be classified as operating leases. For questions related to your business, we suggest talking with a tax professional.
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 $1 million―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. 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.
Types of Equipment Leases
Equipment leases come in several variations with key differences based on desired payments, term length, and whether the borrower wants to keep the equipment at the end of the lease. Some of these include the $1 buyout, 10% option, 10% purchase upon termination (PUT), and TRAC lease. We’ll discuss each in detail, including qualifications, rates, payments, and tax and accounting treatment.
5 Types of Equipment Leases
Costs | How It’s Treated | Who It’s Best for | |
|---|---|---|---|
Interest rate: 6%-15% Relative size of monthly payments: Highest | Tax treatment: Up to $500,000 of cost of equipment can be deducted in first year under Sec. 179 Accounting treatment: Equipment & lease appear on balance sheet Type of lease: Capital lease | Borrowers who want to purchase the equipment, but want to spread out the cost of the equipment into equal payments instead of having a larger lump sum at the end of your term | |
Interest rate: 7%-16% Relative size of monthly payments: Medium | Tax treatment: Up to $500,000 of cost of equipment can be deducted in first year under Sec. 179 Accounting treatment: Equipment & lease appear on balance sheet Type of lease: Capital lease | Businesses that aren’t sure if they want to purchase the equipment or not at the end of the term | |
Interest rate: Varies, but typically has the highest long-term cost Relative size of monthly payments: Lowest | Type of lease: Operating lease Tax treatment: Only monthly rental payments can be deducted as an operating expense Accounting treatment: Doesn’t appear on your balance sheet | Businesses acquiring equipment that they know they will replace at the end of the term or equipment that has a very short shelf life | |
Interest rate: 7%-16% Relative size of monthly payments: Medium | Type of lease: Capital lease Tax treatment: Up to $500,000 of cost of equipment can be deducted in first year under Sec. 179 Accounting treatment: Equipment & lease appear on balance sheet | Businesses that want to purchase the equipment at the end of the term, but need a lower payment than the $1 buyout or 10% option leases would provide | |
Interest rate: 6%-12% Relative size of monthly payments: Varies based on type of lease; overall, this would fall into the medium category | Type of lease: Can be a capital lease or operating lease Tax treatment: Depends on if it is written as a capital lease or operating lease Accounting treatment: Depends on if it is written as a capital lease or operating lease | A TRAC lease is only for vehicle purchases or leases; it is right for those who need more flexibility in deciding how much to pay at the end of the term if you want to purchase the vehicle |
We recommend speaking with a certified public accountant (CPA) or tax professional about these options before you make your decision.
$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. Because 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.
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.
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. The advantage is there is no balloon payment due at the end to transfer ownership.
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.
$1 Buyout Lease Rates, Qualifications, and Payment
A $1 buyout lease likely has the least strict underwriting qualifications as well as the lowest interest rates with ranges of 6% to 15% since you are paying all but $1 of the equipment’s value during the term of the lease. It is likely to carry the highest monthly payments because your lease payments are based on 99% of the equipment’s total cost.
Interest rates are likely to be the lowest on a $1 buyout lease and, by the end of the lease, the equipment will be all but fully paid off. Similarly, buyers may experience higher approval rates on $1 buyout leases, assuming they can afford the monthly payments.
$1 Buyout Lease Tax and Accounting Treatment
Here’s a look at the tax and accounting features of a $1 buyout lease:
- Depreciation: Equipment value can be deducted under Section 179 up to $1 million
- Payment deduction: Interest payments can be deducted as interest expense
- Balance sheet: Equipment must be listed as a liability and asset
The equipment will show up as an asset on your balance sheet, and the lease will show up as a corresponding liability. This contributes to the overall debt your business carries, which may make obtaining another loan more difficult.
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 that the 10% option lease offers a smaller monthly payment. It also offers the borrower the flexibility to walk away from the equipment at the end of the lease, forgoing the 10% payment.
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 $250,000 in funding with as little as 5% down. See if you qualify today.
10% Option Lease Rates, Qualifications & Payment
A 10% option lease is likely to have slightly more strict underwriting qualifications, compared to a $1 buyout lease. Similarly, you can expect slightly higher interest rates, with a range of 7% to 16%. Because you’re only paying 90% of the equipment’s total value over the life of the lease, you can expect marginally lower monthly payments. Borrowers should also expect slightly higher interest rates, with a range of 7% to 16%
The same rules apply regarding a down payment: the more money you can put down at the beginning of the lease, the lower your monthly payments for the duration of the lease. Ultimately, a 10% option lease will fall somewhere between a $1 buyout and fair market value lease regarding payments and interest rate.
10% Option Lease Tax and Accounting Treatment
Here’s a quick look at the tax and accounting features of a 10% buyout lease:
- Depreciation: Equipment value can be deducted under Section 179
- Payment deduction: Interest payments can be deducted as interest expense
- Balance sheet: Equipment must be listed as a liability and asset
The equipment will show up as an asset on your balance sheet, and the lease will show up as a corresponding liability. This contributes to the overall debt your business carries, which may make obtaining another loan more difficult.
FMV Lease
An FMV is 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.
An 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. Because 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 an FMV Lease?
An FMV lease is ideal for software and technology products, or other equipment that quickly becomes obsolete. At the end of the lease, you can return equipment to the leasing company and upgrade to newer technology. 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. An 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.
FMV Lease Rates, Qualifications & Payment
FMV leases are the hardest to qualify for. Since you’re not paying the full value of the equipment you’re leasing, at the end of the term, the leasing company has the burden of recouping the remaining value of the equipment. As a result, FMV leases typically require a strong credit score (650 or higher) and are easier to obtain on more expensive equipment ($150,000-plus).
With an FMV lease, the lessor is taking on significantly more burden as the lease payments typically do not equal a majority of the equipment value. Although payments are lower with an FMV lease, if you ultimately intend to own the equipment, the total amount paid will typically be higher as the corresponding interest rate will be higher compared to a 10% or $1 buyout lease.
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 the lease ends.
FMV Lease Tax and Accounting Treatment
Here’s a quick look at the tax and accounting features of an FMV lease:
- Depreciation: Depreciation is not available
- Payment deduction: Full payments are deductible as operating expenses
- Balance sheet: Equipment must be listed as a liability and asset
Under new guidelines, operating leases over 12 months in length no longer qualify to be kept off your balance sheet. Both the asset and liability must be recorded, according to FASB updated standard 2016-02.
10% Purchase Upon Termination 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 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 during 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.
10% PUT Lease Rates, Qualifications & Payment
10% PUT leases are similar to 10% option leases, except the purchase at the end of the lease is guaranteed by the contract, so the borrower does not have the option to walk away. This shifts the burden from the lessor to the lessee. This lease is typically easy to qualify with bad credit.
Fundamentally, the 10% PUT lease works the same as the 10% option lease. You can expect similar payments and interest rates to a 10% option lease with more relaxed underwriting criteria. Keep in mind that the PUT doesn’t allow the borrower the option to walk away from the equipment so make sure that you factor in the balloon payment at the end of the term, as it will be required.
10% PUT Lease Tax and Accounting Treatment
Here’s a quick look at the tax and accounting features of a 10% PUT lease:
- Depreciation: Equipment value can be deducted under Section 179
- Payment deduction: Interest payments can be deducted as interest expense
- Balance sheet: Equipment must be listed as a liability and asset
As with the majority of leases, including the $1 buyout and 10% option lease, both the asset and the corresponding liability must be recorded by your business.
TRAC Lease
A terminal rental adjustment clause (TRAC) lease can be a capital lease or operating lease and is useful for financing semi-trucks and other vehicles. With a TRAC lease, the future purchase price is known at the time you sign the lease, and your monthly payment is based on that price.
There is a lot of flexibility with a TRAC lease because of its ability to be written as either a capital or operating lease. It can give you room to negotiate your purchase price based on what you think the vehicle will be worth at the end of the financing term. It can be a great option for borrowers wishing to pay a larger portion of the equipment off 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 the financing term. For example, if you want to pay 25% of the cost at the end of the term, 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.
TRAC Lease Rates, Qualifications & Payment
A basic qualification of the TRAC lease is that it can only be used for leasing a commercial vehicle. As a TRAC lease is more flexible than the other equipment leasing options and has the potential for lower monthly payments, it will typically go to better-qualified borrowers. The interest rate can vary greatly based on your credit profile as well as the negotiated payoff at the end of the lease.
TRAC leases can be both a capital or operating lease. Capital TRAC leases have the potential for lower payments, as you can negotiate the amount due at the end of the lease. Written as an operating lease, a TRAC lease offers the lower monthly payments associated with an FMV lease. This option is best suited to a commercial vehicle lease where you do not want to own the vehicle at the end of the lease.
To learn more about what your monthly payment might be, you can check out our equipment lease calculator.
TRAC Lease Tax and Accounting Treatment
Here’s a quick look at the tax and accounting features of a TRAC lease:
- Depreciation: If written as a capital lease, can be depreciated; if written as an operating lease, cannot be depreciated
- Payment deduction: Full payments are deductible if written as an operating lease; otherwise only the interest paid can be deducted as interest expense
- Balance sheet: In most situations, equipment must be listed as a liability and asset
Similar to other lease types, accounting rules call for both the asset and liability to be carried “on the books” for any lease over 12 months.
Leasing Equipment Example
Let’s take a look at two of the most common lease types, the $1 buyout and 10% option, to see how the payment varies. For this example, we’ll assume you’re leasing equipment worth $100,000 over five years.
Here’s a quick look at the variables associated with each example:
- 10% option lease: Emphasizes lower monthly payments over the term, with an optional balloon payment at the end of the lease of 10% of the asset’s value
- $1 buyout lease: Has higher monthly costs over the life of the lease but eliminates the balloon payment at the end
As you can see in this example, your monthly payment would be $264.94 lower on the 10% option lease. However, at the end of the lease, you would have a balloon payment of $10,000 due to own the equipment. The advantage of the 10% option is you can still walk away from the equipment if you decide you don’t want it and save $10,000 in this example.
Many businesses find it much easier to carry the cost in a higher monthly payment rather than having a large balloon payment due at the end. Those businesses would lose the flexibility of walking away from the equipment at the end of the lease but may find that their cash flow is more predictable in this scenario.
Equipment Loan Alternative to Leasing Equipment
When you use an equipment loan, you own the equipment. The loan 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.
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 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 want 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.”
Bottom Line
As you can see, many considerations 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 becomes obsolete, consider 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 Smarter Finance USA. With a credit score above 600 and as little as 5% down, your business may qualify for up to $250,000 in equipment financing. Apply online to qualify in as little as one hour.
Rick Sieradzki
As a follow up to the balloon lease, we are a very seasonal company and lease 15 – 20 machines for a three month period. We have the option to purchase the equipment at the pre-determined retail rate, less the amount that we already paid on the lease. I do not consider this a bargain agreement since we would be paying the full amount. We decided to purchase 6 of the machines. Do I capitalize just the amount that we paid at the end of the lease term as equipment or do I reverse lease costs and capitalize the full retail value of the 6 machines?
TM
Hi, I’m a small business owner in California. A few years ago, I signed a capital lease with a $1 buyout option for equipment. The equipment cost was $35k. To date I’ve paid $39k. When I asked for an early payoff, I was blown away to find the amount at $43k. Is this even legal to have such high charges? Thank you for your time.
Jeff White
Hi TM!
This is certainly legal, which is why you have to be so careful in investigating any financing agreement. Many agreements require you to agree to pay a certain amount of money, regardless of when you pay it off. So if the loan is amortized into equal payments over a 10 year period, you have to make each payment regardless of when you decide to pay off the balance. Each monthly payment requires interest, even the future payments you haven’t made. Many loans and equipment leases are like this, and there’s really no benefit to paying it off early other than you not having to worry about making payments for the rest of the term. Other financing agreements that don’t work this way could also have early payment fees associated with your agreement. This means that when you try to pay it off early you get bombarded with so many fees that it’s not worth it, because there are little if any savings.
Best,
Jeff
Bill merino
I have a Trac lease but am not small business owner. Is that allowed? The lease identifies lessee, guarantor, and lessor. The guarantor is blank, does that mean that the contract is null and void? The residual was calculated at 70.27% on lease or 53390 but stated it was 60% 45594. 7500 credit was not offered to lower monthly Payments. Bank requested all 24 months payments up front approximately 40k is this illegal? Rent charges were at 40% monthly. Total rent was 9229 total depreciation was 23680 could this be usury? Bank has exited leasing and wants 18k and car for personal use back. They won’t negotiate on fair market value which they say is 35k. Standing strong on residual value of 53k. If I pay 18k then i have paid 58k on a 2 year lease with original value of 75900. If i purchase the car 53 plus 40 i woukd have paid Bank 93k plus they get the 7500 Tax credit on the back end. Bank is in Texas and lease is in California. Does this bank need license in CA, CFLL? What are your thoughts on my points? Do i have any recourse?
Jeff White
Hi Bill!
These things are almost impossible to give you a completely accurate answer on without studying your lease and the documents surrounding your relationship with your lessor. I can say, however, that a lease doesn’t have to have a guarantor to be valid. It just needs a lessee and a lessor, so I doubt that would make your lease void. It’s also not illegal for the bank to request upfront or early payments. Whether they can enforce what they’re asking for depends on the legal terminology surrounding your lease agreement (or any other agreements you’ve signed with them).
Some leases are not designed to be bought at the end of your lease, because you would end up paying more for the equipment or vehicle than you would if you bought it brand new. Usually this is due to the interest you’re forced to pay in exchange for the convenience of getting a lease to use the vehicle. It sounds like you have a situation that is frustrating to you, and to make sure you get a full analysis of your situation you should discuss this with an attorney that is familiar with the leasing laws of your state.
Best,
Jeff
raj
Superb article, nicely organized, informative !
Ian Atkins
Thanks, Raj. We’re glad you liked it!
Best,
Ian
Sue
If we have a lease with a 5000 balloon at the end, if we pay it off early do we still have to pay the 5000
Priyanka Prakash
Hi Sue,
Balloon leases/loans are designed to give you lower monthly payments followed by a large “balloon” payment of the outstanding balance at the end of the lease. Paying off the loan early won’t change your obligation to pay back the full balance of the lease. However, you should carefully review your lease terms. If you have a Fair Market Value lease, what’s called the ‘balloon payment’ may actually be the amount you would have to pay if you decided you wanted to own the equipment. Ownership is optional–you don’t have to buy the equipment at the end of the lease. You can return the equipment.
Hope that helps!
Regards,
Priyanka