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Leasing assets instead of buying them outright can be a useful option for your business. This could be because you do not have the money upfront to buy the asset, or you want better financial terms that will suit your specific circumstances. You can do so using a finance lease, where someone leases the asset to you, and you pay them back in regular instalments. For example, say you wish to hire a fleet of cars for your company. Here, you could do so with a finance lease. If you are considering entering into a finance lease, be sure to consider the circumstances of your business and whether leasing is the right option for you.This article will explain what a finance lease is and will outline other key information about finance leases.

What Is a Finance Lease?

A finance lease is when someone (the lessor) lets you (the lessee) rent out their asset for a fixed amount of time, making rental payments back to them. Often, the lessor will be a person or company that purchases the asset, such as a piece of equipment or vehicle. They will then lease it to you for a time that you both agree on. You will have full rights to use that asset for that specified time, and you can add it to your balance sheet. There is sometimes an option to buy the asset at the end of the lease.

For example, a hire purchase agreement for the lease of a forklift could be a kind of finance lease. A finance lease effectively transfers the risks and rewards of ownership to you. If you have an option to purchase at the end of your lease, you can legally own the asset as well. However, this depends on the exact nature of your finance lease. It is, therefore, crucial to read through your lease document carefully and understand how it works.

The lessor can account for GST (goods and services tax) over the period of the lease because they purchased the asset. This means that they can exclude GST from rental payments. The lessor will recover the cost of the asset from you through your regular rent payments and interest.

Differences Between a Finance Lease and an Operating Lease

An operating lease functions similarly to a finance lease, in that the lessor still leases an asset to you for a fixed amount of time, and you pay them back through rent payments. However, these two kinds of leases have a few differences. These include that:

  • an operating lease does not have an option to purchase at the end of the lease;
  • the rent payments for an operating lease likely will not cover the full value of the asset itself;
  • at the end of your operating lease, you return the asset without any further responsibilities;
  • you may not have to pay an upfront deposit in a finance lease; and
  • the running costs of operating the asset are included in payments for an operating lease. This may not be the case for a finance lease, so there may be other administrative costs involved.

Rent Payments Under a Finance Lease

It is important to detail in your finance lease document how you will make your rent payments. This includes defining:

  • the schedule of payments;
  • whether GST is deductible;
  • the value of each payment;
  • whether interest is collected; and
  • what happens if you cannot make a payment.

These provisions will depend on whether there is an option to purchase the asset when the lease ends.

Residual Value of Assets

In some finance leases, when you are negotiating, you will agree on the “residual value” of the asset you are hiring. This is what the value of the asset would be at the end of the lease. You usually base this on:

  • the market value of the asset; and
  • how you intend to use it over the lease period.

If you choose to exercise your option to purchase, this is what you would pay to buy the asset.

However, it is important to note that you do take on a risk by agreeing to pay this residual value. You may use the asset more than you expected during your lease, reducing its value lower than the expected residual value.

For example, say a vehicle you leased had a higher mileage than you expected at the end of your lease. This may lower its overall worth, meaning that you are paying more than you expected. The residual value of the asset may not be the same as its actual value at the end of the lease.

Key Takeaways

A finance lease is a kind of lease where you (the lessee) hire out an asset that someone else (the lessor) has purchased, like some equipment or a vehicle. You make regular rent payments back to the lessor, and you may have an option to buy the asset at the end of the fixed lease period. However, it is crucial to consider your own circumstances to determine whether a finance lease is the most cost-effective option for your business. If you would like more information or help with your finance lease, contact LegalVision’s leasing lawyers on 0800 005 570 or fill out the form on this page.

What is a finance lease?

A finance lease is a kind of lease where someone purchases an asset and leases it to you for a period of time, with an option to buy the asset from them at the end of a lease. A hire purchase agreement is an example of a finance lease.

How do finance leases work?

Someone will purchase an asset, and let you use it for a certain amount of time. You pay them back with rent payments until the lease term is up. At the end of the lease, you will pay the lessor the residual value of the asset, and then you own the asset after that.

What is an operating lease?

An operating lease is similar to a finance lease, except there are a few differences. An operating lease does not have an option to purchase the asset at the end of the lease, so this will affect how rent payments are made. The costs that make up these rent payments are also different.

What does residual value mean?

Residual value is the number you calculate when negotiating your finance lease that represents the value of the asset at the end of the lease. This is based on the market value of the asset, and how you intend to use it during the lease.

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