An operating lease allows small businesses to acquire equipment while conserving cash flow and allowing for frequent replacement to avoid equipment obsolescence. Payments are generally lower than equipment loan payments, though you will likely pay more overall if you keep the equipment. Any lease that doesn’t meet finance lease criteria is considered an operating lease.
What is an Operating Lease?
An operating, or fair market value, lease allows a business to rent equipment or other necessary assets to run their business. Like a common auto lease, with an operating lease you agree to a set number of payments in return for use of the equipment, and at the end have the option to either turn the equipment in, or buy it at fair market value.
With an operating lease, you can expect to negotiate a specific payment amount, payment frequency, as well as lease term. Payments on operating leases are typically due monthly; however, options are sometimes available for different payment frequency and for skipping payments for seasonal lulls. An operating lease does not convey certain benefits of ownership such as asset depreciation, and any purchase option would be at fair market value.
To qualify as an operating lease, the lease must not meet criteria to be considered a capital lease (now known as a finance lease). A finance lease is essentially any lease in which the lessee will have paid a substantial percentage of the market value of the asset, or has a purchase option for less than the market value of the asset.
Who an Operating Lease Is Right For
An operating lease works well for business owners who need an asset that they expect to become obsolete quickly or will want to replace rather than purchase at the end of the lease. With an operating lease you can acquire equipment needed to grow your business, while deducting the full payment as an operating expense.
Some reasons you may want to consider an operating lease are:
- Businesses that need to replace equipment frequently: If your business requires equipment that needs to be replaced frequently, it likely doesn’t make sense to purchase the equipment.
- Businesses that want to benefit from larger tax deductions: The full payment on an operating lease qualifies as an operating expense and can be taken as a deduction against your taxable income.
- Businesses that need software or other assets that quickly become obsolete: Many assets are at risk of obsolescence, and as a result you may want to consider a short-term lease that gives you the flexibility to upgrade frequently.
- Businesses that need the equipment but don’t want to purchase: If you need to acquire an asset temporarily (i.e., you just secured a contract, but require a piece of equipment you do not normally need), an operating lease can help you get the equipment without locking you into ownership.
An operating lease can give your business the flexibility to replace equipment frequently, avoid costly ownership of that equipment, and allow you to upgrade the equipment according to the frequency dictated by your market. If you decide you want to own the asset, an operating lease gives you the option to purchase at fair market value at the end of the lease.
Operating Lease vs Short Term Rental
The most notable difference between an operating lease and rental is the length of the agreement. An operating lease is typically for a longer period of time (one to five years) where a rental is typically much shorter—anywhere from one day to several months, depending on how long the equipment is needed.
A second differentiating factor is maintenance of the asset. When you lease a piece of equipment using an operating lease, you’re typically responsible for maintaining the equipment while it is in your possession. Conversely, with a rental, maintenance typically falls on the organization that owns the asset.
A final differentiating factor between these two methods is the equipment itself. With an operating lease, you have the ability to specify the exact equipment you are leasing, as well as whether that will be new or used equipment. Rentals are often used, and you will have less control over the specific equipment you are renting in terms of age, brand, and how many hours of use the equipment has.
Operating Lease Costs
Operating lease costs vary depending on a variety of different factors, including the length of the lease term, your creditworthiness, as well as the equipment being financed. Typical costs include a down payment up to 20%, interest between 5% – 15%, documentation fees, as well as site inspection fees when appropriate.
- Down payment (up to 20%) : A down payment may be required in order to secure a lease, and will depend upon creditworthiness as well as the targeted payments. The down payment will apply toward the total value of the lease payments, but may not equal equity in the asset unless you exercise the option to purchase.
- Interest (5% – 30% APR): Unlike personal car leases, which include a money factor, an operating lease will be based on the total value of the equipment, the value that you’re financing, and the residual value. Interest and operating expense can be recovered through tax deductions.
- Document fees ($100 – $600): Document fees may be applied by the lender as a way of covering their processing costs, and vary based on deal complexity. This is similar to the loan document fee you might see on a car loan, and is sometimes negotiable.
- Site inspection fees ($100 – $200): This fee may apply depending on the asset and lender, and covers a physical inspection of the asset at your place of business.
Lease terms are typically negotiable, and it is a good idea to compare quotes from at least two different lenders to make sure you’re getting the best terms for your lease. Business owners should be aware that factors such as the condition of the equipment, the length of the term, and personal and business credit, can all impact your operating lease costs.
Operating Lease Monthly Payment Example
If you’re considering an operating lease, it’s likely because your business would benefit from lower monthly payments than that of a typical loan or capital lease. Like a loan, several factors can impact your monthly payments. These include your down payment (if any), your interest rate, and the term of the lease.
For this example, the asset will be a piece of heavy machinery, with a total value of $100,000. For our purposes, we’ll base the residual value of the asset on straight line depreciation of an asset with an estimated useful life of 10 years. This will give us some nice even numbers to work with. Keep in mind, your asset’s actual useful life will vary depending on the type of asset.
Operating Lease Payment Examples
5 years at 10%
5 years at 7.5%
3 years at 10%
In the first two examples, we can see how negotiating for a lower interest rate leads to less money paid toward the lease over time, in this case saving our hypothetical borrower $9,315 over the five year term. Getting the lowest interest rate possible can significantly impact borrowing costs.
In our third example, we keep the interest rate the same as the first example, and instead lower the term to three years from five. This saves our business owner $38,314.92 in payments, and is a great option if you’re not planning to keep the equipment.
Types of Operating Lease Providers
If you have chosen to finance equipment for your company with an operating lease, you have several important decisions to make, including what type of provider to use. Typically you can get an operating lease from a traditional bank, an alternative lender, or an in-house or “captive” financing company.
Some providers of operating leases to consider are:
Not all banks offer operating leases but those that do offer advantages that include working with a lender with a solid reputation, building a banking relationship with a lender, as well as refinancing options should circumstances change. However, these lenders also typically have strict credit requirements to qualify, plus at least two years in business, supporting tax returns, and both business and personal financials.
Operating leases are more common with alternative lenders who offer more creative leasing options, greater flexibility in payment options, as well as more lenient underwriting criteria, with some lenders willing to work with startups on their first day in business. Generally, good credit is still preferred, but alternative lenders are usually willing to work with poor or no credit as well.
In-house (or captive) financing is financing that is offered by the equipment manufacturer or reseller. Lenders typically offer credit to more challenged borrowers, have higher approval rates, and may even subsidize the equipment, leading to lower overall costs. Captive lenders often will not finance used equipment and are usually locked into a specific manufacturer or range of equipment.
Understanding Residual Value
Residual value is the monetary life left in the asset after the lease is over. The lessor will have the opportunity to recapture the residual value by leasing the equipment again, or by selling it. An operating lease’s residual value can be significant compared to the amount the lessee is paying over the length of the lease, and so the final payment to purchase the asset can be quite large.
Understanding the residual value of the asset is important, as the lessor will largely base the lease payments on this value. If you intend to purchase the asset at the end of the lease, consider a $1 or 10% purchase option lease. While monthly payments will be higher, you will likely pay less for the asset compared to an FMV lease.
Alternately, with an FMV lease you may purchase the asset at the end of the term at fair market value; however, you will likely pay more overall to acquire the asset this way, especially if the asset holds its value particularly well.
Changing Operating Lease Standards
For fiscal years beginning after Dec.15, 2019, private businesses (with revenues under $25 million) will need to begin accounting for leases under the updated FASB Accounting Standards, 2016-02. All other organizations have been subject to these new rules since Dec.15, 2018.
Under the new rules, capital leases have been updated and replaced by the finance lease. The qualifying criteria of a finance lease has been updated to remove any bright line definitions, leaving defining a lease as a financing lease largely subjective.
In addition to new finance lease criteria, business owners must now recognize all leases on their balance sheet as assets and liabilities, eliminating a special incentive for businesses to use operating leases as a way to keep assets off their books. An exception to this requirement is made for any leases with a term of 12 months or less.
Pros & Cons of the Operating Lease
Operating leases have several advantages such as frequent replacement of obsolete assets, full expensing of operating costs, and lower monthly payments, but they’re not always the best fit. Over time you may pay more for equipment, and you’ll need to list the item as an asset as well as a liability on your books, similar to a capital lease.
Pros of the Operating Lease
Some pros of financing assets with an operating lease include:
- No ownership obligation: With an operating lease, there is no expectation that your business will purchase the asset at the end of the term. This allows you to replace equipment more frequently and avoid obsolescence.
- Operating costs are fully deductible: Payments made on an operating lease may be deducted as operating costs to offset taxable income.
- Lower monthly payments: An operating lease will typically have lower monthly payments, as the payments are negotiated for less than the total asset value.
Cons of the Operating Lease
Some typical cons to an operating lease are:
- Higher equipment cost: If you continually replace your equipment through rolling leases, eventually you will have paid more than the value of the asset had you bought it outright.
- Increased liabilities: As of Dec.15, 2019, all businesses will be required to carry operating leases over 12 months in length on their balance sheets both as an asset as well as a liability.
- No benefits of ownership: Operating leases are not considered a form of ownership, so you are unable to claim depreciation of the asset to offset income.
Alternatives to the Operating Lease
Operating leases can still be a good choice for your business, but changing rules may impact how beneficial they can be. You may want to consider a capital lease, which comes with the benefits of ownership, a traditional loan which may allow for more financing flexibility, or a short-term rental which may save you unnecessary expense.
Some of the most popular alternatives to an operating lease are:
With a capital lease, you receive all of the benefits of leasing, with the added benefits of ownership, meaning you can depreciate the asset according to IRS guidelines, which will allow you to offset taxable income. Of course, with that comes the risk of obsolescence, and you won’t be able to write off the principal portion of the lease payments as an operating expense.
If you already have a strong banking relationship, you might get a better rate and term with a traditional equipment loan. If you would like to own the asset at the end of the term, a traditional loan is the most straightforward way to achieve that, and if you need working capital you can often get one loan to solve several challenges. Downsides include less flexibility in terms, and potentially stricter underwriting guidelines.
If your need for the equipment or asset is temporary, and near term, you may save considerable expense by pursuing a short-term rental. Advantages include avoiding responsibility for maintenance and repair, as well as down time, as you can usually replace out of commission equipment immediately. And while rates may be much higher in the short term, the equipment can be returned when it is no longer needed, saving money in the long term.
Operating Lease Frequently Asked Questions (FAQs)
Hopefully this article has answered your most important questions regarding operating leases. We’ve included some of the most frequently asked questions about operating leases below. If you have any remaining questions, please ask in the comments below, or visit our forum.
Can you depreciate an operating lease?
Since an operating lease is not considered ownership, the asset is not able to be depreciated in order to offset income. Leases that qualify as finance leases may be depreciated, as well as equipment financed using a traditional loan.
Is a lease considered debt?
For the purposes of tax preparation, an operating lease must be listed as both a right-to-use asset, as well as a corresponding liability. However, from an accounting perspective, an operating lease is not considered debt, and is accounted for as an operating expense.
What is the difference between a finance lease and an operating lease?
Key differences between a finance lease vs operating lease include whether the payments equal a significant percentage of the value of the asset, and whether the term of the lease constitutes a majority of the expected life of the asset. Finance lease assets can be depreciated, while only interest paid may be deducted from taxes.
An operating lease is a flexible option that should be considered by business owners who are looking for the benefits of leasing equipment, and want to avoid ownership. You’ll want to consider this option if your business benefits from frequently updating equipment, or has a shorter term need for the asset.