Equipment leasing can be an attractive option when buying and maintaining equipment is too big of an expense for your small business.
Leasing can come with low upfront costs and low regular payments, but it can also result in paying more over time than if you paid for the equipment outright.
An equipment lease is a contractual agreement between the owner of the equipment (the lessor) and a small business owner (the lessee) who wants to use the equipment for a specific period in exchange for set payments.
In some cases, the lease allows the lessee to purchase the equipment at the end of the term. Otherwise, you can renew your lease or let the lessor take the equipment back.
Leasing gives business owners access to vehicles, machinery and equipment that they may not be able to afford otherwise.
How does equipment leasing work?
Depending on your type of lease, it may function similarly to equipment financing or a rental agreement. Either way, you pay fees in exchange for using an asset.
With machinery leasing or business equipment leasing — or even if you’re leasing IT equipment — your business doesn’t have to tie up a lot of cash into purchasing equipment. You also won’t have to spend time trying to find a buyer once you no longer need the equipment. Those risks and responsibilities fall on the company that owns the equipment.
Nearly any type of machinery or business equipment can be leased, so the options and terms of lease agreements can vary to accommodate different industry practices and needs. The equipment you lease might be new or used.
A typical equipment lease lasts two to five years, and at the end of the lease term, you may have to return the equipment or you might have the option to purchase it.
Leasing provides a lot of advantages over buying equipment, but that doesn’t mean it’s without its downsides, too.
| Pros | Cons |
|---|---|
No down payment needed. You can try equipment before you buy it. You can deduct lease payments on taxes. Smaller monthly payments are easier on cash flow. It’s easier to upgrade your equipment to the newest version in evolving industries. | More expensive in the long run. You don’t own the equipment. There may be fees for excessive equipment use. Some lease types mean you can’t claim depreciation on your tax return. It may be expensive or impossible to break your lease early. |
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Types of equipment leases
There are generally two types of equipment leases: capital leases and operating leases.
Capital leases
Capital leases are also known as “financial leases,” and they function similarly to a business equipment loan with one big difference: The small business owner doesn’t get the title to the equipment right away, as with a loan. Instead, at the end of a capital lease, the business owner might get the option to buy the equipment for a nominal amount (often just $1) or the fair market value, or they can return the equipment to the lessor.
Taking on a capital lease is a big decision: You can’t cancel the lease, and since you don’t own the equipment, you can’t sell it and cut your losses like you can with a loan.
Capital leases are usually made for the length of the useful life of the equipment, so they can last many years in some cases.
Since they’re designed as a pathway to ownership, you can expect a similar experience to actually owning the equipment, minus the title. You’ll make similar payments with a capital lease as you’d be making with a loan, and you’ll be responsible for maintenance.
You’re generally considered the owner for tax and accounting purposes, so you may even be able to claim depreciation on your taxes and include the asset on your business balance sheet.
Operating leases
Operating leases are designed more like rental contracts. You won’t be leasing the equipment for its full useful lifespan (unless you renew it), so they tend to be shorter-term in nature and have lower monthly payments.
The lessor bears the responsibility for maintaining the equipment, and you’re generally able to cancel the contract early if you’re willing to pay early termination fees.
These types of equipment leases may work better for business equipment that becomes obsolete very quickly or if your equipment needs might change frequently, like if you’re hoping to quickly upgrade to better equipment as your business expands.
Equipment lease rates and terms will vary by contract, but here are some general details.
Interest rates
Equipment leases generally offer fixed rates for the duration of the contract. These rates will depend on:
- Your credit
- The business’s industry
- The type of equipment you lease
Other costs of leasing
Before signing a lease agreement, be sure to review all paperwork thoroughly so you understand the total cost. Some lease agreements offer lower equipment lease rates but make up for it in fees or require the lessee to cover taxes and insurance costs.
Here are some fees you may face.
- Origination fees: These are designed to cover the upfront costs of approving your lease, including reviewing your credit and handling the paperwork.
- Interim rent: This can be charged by lessors for the time between when the equipment is installed and when the first lease payment is made.
- Insurance: Check with your leasing company to find out if your contract includes insurance. If not, you’ll want to insure any leased equipment.
- Late fees: These can be charged by the lessor if you’re late on a lease payment. Typical late fees are 10% of the amount due.
- State or local taxes or fees: Some state and local governments assess taxes on rented or leased equipment. For example, Oregon charges a 2% tax on certain heavy equipment rentals. Talk with your leasing company and check local laws to find out what taxes you may be responsible for.
Terms
The duration of the lease depends on your needs and the cost of the equipment. It can be short term or long term.
- Short-term leases could be preferable for companies with changing needs or equipment that becomes obsolete quickly.
- Long-term leases could be more convenient and affordable for costly equipment that’s designed to be used for decades.
Some leases may include provisions for early termination or renewal.
The equipment lease agreement will specify your payments and when they’re due. The contract may also specify how the payment should be made — whether that’s via check, wire transfer or autopay — and what happens if the lessee doesn’t pay on time.
Some leases also require a security deposit, which could cover potential damage to the equipment during the lease. However, if damage to the equipment is greater than the security deposit amount, the lessee may be liable for the difference.
The security deposit may also help offset the lessor’s costs if the lessee doesn’t make the agreed-upon payments and the lessor has to repossess the equipment. The lease agreement should spell out how the security deposit can be used.
Market value
When the lease involves expensive equipment, the agreement might disclose the market value of the machine. This helps the lessee determine the level of insurance coverage for the equipment.
Cancellation provisions
The agreement will lay out the procedures for canceling the lease before the term has ended. Depending on the type of lease, this may involve giving the lessor proper notice or paying an early termination penalty.
How to get an equipment lease
If business equipment leasing is the right move for you, here’s how to get started.
Step 1: Determine your budget
Leasing usually offers lower monthly payments and lower upfront costs than business equipment financing. However, you still need to factor those costs into your budget. Start by figuring out what you can afford to pay upfront — and per payment — and go from there.
Step 2: Figure out how long you’ll use the equipment
Will you need a long-term or short-term lease? That depends on the type of equipment you need and whether that type of machinery or equipment becomes obsolete quickly.
Step 3: Compare leasing companies
Start by checking if any leasing companies serve your particular industry, since they may be able to tailor the lease more to your needs. Keep in mind that many equipment leases are often made directly by the manufacturers themselves, but they may also be offered by independent companies and brokers.
Look at as many reviews of the company as you can find to see what other people’s experiences have been like, and check for any past lawsuits or government sanctions that could indicate shady behavior.
Try contacting the company to ask questions and get a handle on how well it handles customer service. Ask if they can provide you with a range of rates or a sample contract without submitting to a hard credit check yet, since this can tell you what costs you may have to pay before you commit to applying for an equipment lease.
Step 4: Make sure you qualify
Leasing companies look at various factors when evaluating a machinery leasing application, including:
- Length of time in business: Companies that have been in business for two or more years may have an easier time getting approved for financing than startups.
- Credit scores: Leasing companies may look at the business’s credit score, as well as the business owner’s personal credit score. Each business equipment financing company sets its own standards for minimum credit scores. If the owner’s credit score is below 620, the company will have a tougher time getting approval.
- Cash flow and profitability: If you don’t have a strong credit score, you may still qualify for a lease based on your company’s financial performance. The leasing company or vendor may want to review your company’s most recent financial statements, tax returns and other financial documents.
Step 5: Gather required documentation and apply
The documentation required for a machinery lease varies depending on the value of the equipment and other circ*mstances of the transaction, but you may need to provide:
- A completed lease application
- A written business plan
- Pro forma financial statements
- Bank statements and tax returns for the business
In our personal world, we’re often told that buying is better than renting — but that’s not always the case in the business world. Leasing may be a good option if you’re not yet able to qualify for financing or if your business doesn’t yet have the cash flow to support larger loan payments.
Indeed, leasing may even be better than buying in certain cases, notably for new technology that may be changing frequently, such as medical equipment or computers. Leasing gives you the flexibility to upgrade more easily without worrying about the sunken costs of owning the equipment.
However, most businesses are concerned about long-term profitability and, in general, buying is cheaper than leasing. Buying may also be a better option if you’ll be holding the equipment for its full expected lifespan.
If both options are available to you, it’s a good idea to use a buy vs. lease calculator to compare the overall costs.
