Leasing vs financing is a key decision for individuals as well as businesses. Both arrangements come with discrete benefits and some limitations.
Let’s discuss leasing v financing and their key differences.
What is a Lease?
A lease is a contract between two parties where the first party (lessor) agrees to let the second party (lessee) use an asset under agreed terms and conditions.
The contract can be made for any type of asset like a car, house, real estate property, machine, software, or any other type of commercial equipment.
Both parties agree on paying a monthly lease payment and the contract term among other conditions. A lease may involve a downpayment and a security deposit too.
Leasing is common for individuals dealing with cars, houses, and household machinery. While businesses use leasing to use costly equipment like heavy machinery, expensive technology tools, software, buildings, and so on.
How Does Leasing Work?
Depending on the lease type, a contract can be arranged differently by two parties. However, all types of leasing agreements have a few common traits.
- Contract term and maturity date
- Monthly payment amount, due date, and late penalty fee
- Obligations and responsibilities of both parties
- Contract breach consequences
- Contact information, addresses, and other essential information
A lease contract can have a termination clause as well. Both parties may mutually agree to certain conditions like a notice period to terminate the lease contract.
A lease contract may include unique clauses depending on the type of leased asset as well. For instance, the lessor may include a patent or trademark protection clause when leasing out complex manufacturing machinery to a company.
Key Features of Leasing
You must consider these key features of leasing something over financing decisions.
You don’t own an asset leased under normal conditions. Most lease agreements are designed only to let lessees use an asset for a defined period only.
Some leases may contain an option to buy the asset at the end of the lease contract though.
Lessors often require a higher level of creditworthiness from lessees as compared to borrowers for financing.
You’ll often need a higher credit score and an established credit history to apply for a lease.
You can always opt for the latest technology and updated asset version under a lease contract. However, the leasing cost may vary for trade-in transactions.
Most leases do not require down payments, unlike loans. However, you may need to pay a few monthly installments upfront as a downpayment for the contract.
Security Deposit or Collateral
Since you do not own an asset with a lease contract, lessors usually do not ask for collateral.
Most lessors would ask for a security deposit though. It can be used to recover your monthly payments, interest costs, maintenance, insurance, and other types of expenses.
Lease agreements come with certain asset usage rights. These contracts also impose certain limits on usage.
For instance, a mileage limit on a car leasing contract is a common practice.
Although a lessee is not responsible for repairs and maintenance of the leased asset, you may have to pay other costs including additional insurance, uncovered repairs, adjusted interest costs, and end-of-lease costs.
Advantages of Leasing
Leasing has a few distinct advantages over financing:
- You get the latest technology for the leased asset.
- Lease monthly payments are usually lower than loan payments.
- Asset substitution or trade-in options are easier with leasing.
- Initial costs including down payments are lower.
- Your leased asset will be protected under warranty.
- The lessor bears the maintenance and repair costs mostly.
- You don’t have to worry about the residual value of the leased asset for resale purposes.
- A well-designed lease contract may bring some tax benefits as well.
Disadvantages of Leasing
Some disadvantages of leasing include:
- You’ll never own the leased asset unless you purchase it at the end of the lease in a separate transaction.
- You’ll have to pay additional costs including gap insurance, out-of-coverage maintenance, lease-end costs, etc.
- Leasing contracts often come with restrictions on asset uses.
- Monthly payments are usually higher in a lease contract.
- Leasing for the latest-technology assets is often difficult.
What is Financing?
Asset financing or simply financing refers to the process of borrowing money by an individual or a business to buy an asset.
Put another way, financing also refers to unsecured loans as this type of lending is often secured by an asset used as collateral by the borrower.
However, the borrower may use a secured loan when buying an asset. The term financing usually refers to loans with no pledged assets though.
Unlike the leasing process, the borrowers own the asset at the end of the financing contract. The borrower pays the full cost of the asset including interest costs paid for the borrowed money.
How Does Financing Work?
Individuals using financing for buying assets require higher credit scores. They must possess excellent credit histories as well.
The lender will usually require a pledge to offer loans if the borrower has an average or bad credit score.
Startups and small businesses often do not own valuable assets to pledge with the lenders. So, they revert to unsecured loans where the lender has a general claim on the assets of a company.
The borrowers can use direct financing from the lenders and make monthly payments until the end of the contract. The lender owns the assets until the last payment is cleared.
Alternatively, the borrower can use the balance sheet assets to pledge and secure financing from the lender. The borrower will own the asset and the lender will be protected against the collateral.
Key Features of Financing
Let’s discuss some key features of financing an asset as compared to leasing.
The borrower owns an asset when using a secured loan. With an unsecured loan, the borrower owns the asset at the end of the loan term though.
Depending on the financing structure, a borrower can obtain a loan with a bad or average credit score as well.
For unsecured loans, a borrower must possess a higher credit score and an established credit history.
You can sell a purchased asset through financing at any time. However, if the loan is backed by the purchased asset, you may lose equity value.
You’ll often require 10-20% of the total asset value as a downpayment. The amount usually depends on the credit score, collateral, interest costs, and residual value of the borrower asset.
You may not need an asset to pledge for financing. However, secured loans will require some sort of collateral.
The use of collateral can lower your financing costs significantly too.
There are no usage restrictions when financing an asset from a lender. You can use the asset as long as you want without any restrictions unlike in leasing.
As a borrower, you are responsible for the maintenance, insurance, and upgradation costs of an asset.
Advantages of Financing
Financing an asset has some key advantages over leasing:
- You own an asset before or at the end of the financing contract.
- You can pledge the asset to obtain financing from a lender.
- There are no usage restrictions on a financed asset.
- You can sell or refinance without any restrictions.
- You can lower interest costs by pledging an asset as collateral.
- You have the choice to control the maintenance, insurance, and other types of costs.
Disadvantages of Financing
Financing an asset comes with some limitations as well:
- The initial costs of financing an asset are higher as compared to leasing.
- You need an asset to pledge or an excellent credit score to obtain financing.
- The residual value of an asset may be lower in the long term.
- You’ll have to pay more sales tax with financing.
- The interest costs of financing are higher than leasing.
Leasing Vs Financing – A Summary of Key Differences
Let’s summarize the key differences in leasing v financing decisions.
|Ownership||The ownership remains with the lessor.||The borrower owns the asset.|
|Accessibility||Leasing requires a higher credit score, often difficult to find a suitable lease.||Secured and unsecured loans are common, and borrowers require good credit scores or collateral.|
|Trade-in Value||The trade-in options are easier with leasing.||You have to sell an asset to purchase a new one with financing.|
|Initial Costs||Initial costs are lower in leasing.||Higher initial costs with financing.|
|Monthly Payments||Monthly payments are lower.||Monthly payments are higher.|
|Collateral Requirements||You don’t need collateral with leasing.||You’ll often need an asset to pledge as collateral.|
|Usage Rights||Leasing offers limited usage rights.||Financing comes with unlimited usage rights.|
|Additional Costs||Most repairs, insurance, and other costs are covered by the lessor but not all.||The borrower bears all types of insurance, maintenance, etc.|
|Residual Value||Lessees don’t need to worry about the residual value of the asset.||The residual value affects the cash flows of the borrower.|