Both lease and financing are fundamental means to fund the purchase of an asset or investment. The end goal is to give the borrower/hirer possession and right to an asset. Both lease and financing enable a business to source valuable assets and utilize them in the furtherance of their business. The below-mentioned definitions will re-enunciate the difference between lease and finance.
What is Lease?
A lease is a binding legal agreement whereby one party holding ownership of an asset (lessor) agrees to rent the underlying asset to another party (lessee) willing to comply with the terms and conditions entailing the lease. The lease payment schedule, term of the lease, and onus of risk are some of the most important covenants of a lease agreement. The two major types of lease are Operating and Financing Lease.
What is Financing?
Financing refers to borrowing money repayable at a certain date in the future. Finance is normally sought from banks, financial institutions, and the like. The main modus-operandi to financing is the concept of the present value of money. For example, banks lend $100 today to receive $106 in the future. The $6 component is the interest component that a lender pays for borrowing money today that he can repay tomorrow.
Difference Between Lease and Finance
This is the fundamental and most important point of difference between lease and finance. In fact, this is what gives a financing transaction its defining character.
The ownership of the asset remains with the lessor. The lessor has complete control over the make and class of asset purchased, negotiations with the vendor, and maintenance of the asset. An asset may remain completely in the custody of the lessee during the life of the asset. However, the lessee only acts in the capacity of a bailee, never gaining any ownership or control over the asset.
The borrower is the owner of the asset from the very inception of the financing arrangement. The bank/financial institution merely acts as a third party in making available funds to purchase the asset. However, in most cases, the asset acquired through a financing arrangement acts as collateral if the borrower defaults. The bank forfeits such property in such cases, and the borrower must forgo his ownership.
The consideration for a lease is the installments payable as per the lease schedule predetermined at the inception of the contract. The composition of the lease payments differs in the cases of an operating lease and a finance lease. In the former, the lease rentals consist solely of the hiring charges. In the latter, the rentals are broken down into the principal component (which covers the asset value) and the interest component.
In a financing arrangement, the entire consideration is divided into the down payment and the installments payable. The down payment is a lump sum amount generally equal to 10 to 30% of the value of the asset. This amount depends upon the credit score and collateral quality submitted. The installment structure is very similar to that of a finance lease. It is broken down into the interest and principal components. This amount is an attributable party towards the asset value and partly to the interest value.
Identifying the owner party is a simple way of identifying the risk-bearing entity. In an uncomplicated world, wherever the ownership is, the risk follows. However, the ever-evolving money market has reduced the validity of this rule.
In most cases, the lessor and not the lessee is exposed to the threat of damage or destruction to his asset. Therefore, the onus of providing for risk and insurance is on the lessor. However, in finance (or capital lease) cases where the lessee possesses the asset for its substantial life, he basically partakes in its risks and rewards. In such cases, the lessee and lessor may mutually decide to share the costs of insurance.
In a financing arrangement, the lending institution is, without exception, exposed to credit risk, insolvency risk, and a hoard of other uncertainties. However, its responsibility will solely be with the borrower when it comes to the asset. For example, a car bought on a mortgage runs into an accident. The responsibility for its repairs will be on the car owner and not the bank. Therefore, the borrower must undertake insurance plans suitable for the nature of the asset.
A lease is generally for a shorter period of time and is taken on to serve very specific purposes. The lessee does not have to pay a lease value equal to the lifetime cost of the asset. This enables a lessee to go for advanced and better models of the same asset. For example, a couple wanting to live in New York city temporarily will be able to afford a nice apartment in Manhattan on a short-term lease. Thus, a lease enables a lessee to up their game by a notch.
Financing is substantially an arrangement for ownership of an asset. The transaction is of irreversible nature, and the asset becomes the permanent property of the borrower. Financing, therefore, forces the borrower to acquire strictly within his means. Continuing the above example, if the couple were looking for a permanent residence, they certainly would not be able to afford the Manhattan apartment. They would have to look for something more affordable, perhaps in the suburban regions.
Warranty and Upgrades
Manufacturers and vendors generally provide an asset warranty that runs from 1 to 3 years. This often coincides with the life of the lease. Therefore, the lessee does not have to worry about routine repairs and breakdowns since they are all well covered under warranty. Also, using assets on short-term leases enables a lessee to stay up to date with the latest technology. He can replace his asset every couple of years and enjoy the benefit of warranties with every fresh lease.
As we already know by now, the borrower acquires an undisputed title to the asset with the payment of the last installment. Until he decides to dispose of the asset, it shall remain with the borrower. Also, he shall quickly run out of the warranty period within the first few years. The continuous repairs and maintenance expense shall be his responsibility in the years to come, often burning a deep hole in his pocket. Also, if he wishes to upgrade from the existing asset, the asset owner will have to go through the hassles of re-selling the asset and perhaps again obtaining a fresh financing arrangement.
Going for loan financing is thus a counter-intuitive approach for a person wanting to remain current and up to date with technology. Leasing is very popular in such cases. On the other hand, assets of permanent nature are better purchased through loan finance. Examples mostly include personal assets such as jewelry, houses, and land.
Difference Between Lease and Finance- Tabulated
The following table encapsulates the entire content into bite-sized information.
|Ownership||With the Lessor||With the borrower. Acquires an undisputed title upon payment of the last installment.|
|Consideration||Lease Rentals. Maybe broken down into principal and interest components in case of a financial lease.||Down-payment & Installment. Installment consists of components that party cover the asset value and partly provide for the financing charges.|
|Risk||With the Lessor. Lessee may share risk in cases where the lease period covers the life of an asset.||With the borrower.|
|Affordability||Very Affordable since the lessee does not have to provide for the full cost of an asset.||Restricts affordability since the borrower is the eventual purchaser of the asset.|
|Warranty and Upgrades||The lease period coincides with the warranty making the lessee worry-free about petty repairs. It also enables the lessee to upgrade to new technology easily.||Warranty runs out quickly, increasing the cost of maintenance. Difficult to upgrade to new technology.|