The Basics of a Financial Lease

A financial lease is also termed a "capital lease," as it is a commercial arrangement between or among two or more parties. In such a financial arrangement, a financial institution will lease a purchased asset to a lessee for an agreed-upon period. The financial institution that leases its asset is also referred to as a "lessor," and the person who leases it is referred to as a "lessee." During the lease period, the lessee gets to use the asset and can buy the asset from the institution at a very low price after the end of the lease period.

Financial Leases

There are various kinds of financial lease by which assets like land, buildings, equipment, vehicles and others can be leased for a specific period. The duration of the lease period varies with different assets. It can be either a long-term or intermediate-term lease arrangement, depending on the life and nature of the asset. Throughout the lease period, the lessor remains the owner, and the lessee has to pay the interest and other applicable payments but can enjoy using the asset.

Legal Restrictions

There are four basic qualification criteria for financial leases in the United States. Every financial lease should satisfy one of these four criteria:

  • The lessor must give the lessee an option of purchasing the leased asset at a low price at the end of the lease period.
  • The purchase price of the leased asset after the end of lease period must be lower than the market value of the asset.
  • The lease period must cover at least 3/4 of the projected life of the asset to be leased.
  • The net value of all payments made during the lease period should cover at least 90 percent of the original purchase value of the asset, so that after the lease and final purchase, the lessor should eventually have made profits.

Noncancelable

Whenever a financial lease agreement is executed for an asset, it is a noncancelable lease. In such type of leases, the lessee has to pay a certain amount every month throughout the lease period without failure. Though the lessee pays this amount, he or she is responsible for the maintenance of and repair work on the leased assets. At the end of the lease period, the lessee can opt to purchase the asset if he or she wants to. Otherwise, ownership will revert to the lessor.

Operational Lease vs Financial Lease

An operational lease is a similar kind of arrangement between a lessor and lessee. However, there are certain differences:

  • In an operational lease, the lessee cannot utilize the asset completely, while this is not so in the case of a financial lease.
  • At the end of the lease period, the lessee would have almost recouped the entire investment in the financial lease, while this is not so in the case of an operational lease.
  • An operational lease can be canceled during the lease period, while the financial lease cannot be.

Final Word

For a new company, purchasing all necessary equipment can be a huge burden. In such situations, the new company can opt to lease a few types of equipment so that it can slowly become the owner of the equipment. Thus, it can save its operating budget for other purposes.

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