Lease Financing Explained – Types, Features, Pros & Cons

What is Lease Financing?

Lease financing is the source of payment that comes when the owner of assets (lessor) is ready to provide their assets to another person in exchange for that lessee provides some agreed payment.

In this way, the lessor leases the assets for a period of time on rent and the lessor gets funds from the lessee. The periodical payment made by the lessee to the lessor is called the lease rental.

Under lease financing agreement, the lessee is given the right to use the assets but the ownership lies with the lessor and at the end of the lease contract, the asset is returned to the lessor, or an option is given to the lessee either to purchase the asset or to renew the lease agreement.

Features of lease financing –

1. A finance lease is a device that gives the lessee the right to use an asset.
2. The money charged by the lessor on the primary period of lease is pretty much sufficient to recover his/her investment.
3. The lessee is responsible for the maintenance of assets.
4. All the profit earned during the lease agreement is for the lessee. The only pre-planned rental has to pay to the lessor.
5. If the lessee starts getting losses during the agreement, then he/she can easily opt-out of it but after the Primary period or locking period. 
6. In case of good profit or returns from the leasing assets then the lessee can renew the same agreement with some rental increment or at the same price.

Types of leasing –

Finance lease is classified into two phrases:

1. Primary period lease
2. Secondary period lease
3. Operating lease

Primary period:

This is the non-cancellable period and in this period or we can also say the locking period. In this time period, no party can cancel the contract of leasing. The lessor recovers his total investment through lease rental and this period may last for an indefinite period of time.

Secondary period:

This period is also known as a peppercorn. It is almost the same as the primary period but in this period the lease rental is much smaller than that of the primary period. 

Operating lease:

Also known as Service Lease, in this type of leasing, the risks and rewards incidental to the ownership of the asset are not transferred by the lessor or the lessee. The term of such lease is much less than the economic life of the asset and thus the total investment of the lessor is not recovered through lease rental during the period of the lease.

In an operating lease, the lessor usually provides advice to the lessee for repair, maintenance, and technical know-how of the leased asset. This option is basically used when there is no lessee ready to rent the assets at any cost. But lessor or assets owner is bearing technical repair and maintenance charges. Then it will be decided to lease out the property at the condition that the lessee has to bear all technical repair and maintenance charges. Some features of Operating Lease are:-

1. The lessor provides the technical know-how of the leased asset to the lessee.
2. Risk and rewards incidental to the ownership of the asset are borne by the lessor.
3. The lease term is much lower than the economic life of the asset.

Advantages of lease financing

To the Lessor:

• Assured regular income: the lessor gets a lease rental by leasing an asset during the period of the lease which is an assured regular income.
• The benefit of tax: as ownership lies with the lessor, the tax benefit is enjoyed by the lessor by way of depreciation with respect to the leased asset.
• Maintenance-free: Lessor can now feel free from that asset because the lessee is going to manage that all. 

To the lessee:

• Tax benefits: a company is able to enjoy the tax advantage on lease payments as payments can be deducted as a business expense.
• Cheaper: leasing is a source of financing which is cheaper than almost all sources of financing. Purchasing a new property or assets is a costly thing. 
• Easy shifting: If the lessee plans to shift their location then he/she easily can move out after the ending of the contract. And can lease a new property at the new location. 

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Disadvantages 

1. To the Lessor:

• Double taxation: sales tax may be charged twice; first at the time of purchase of assets and second at the time of leasing the asset.
• Unprofitable in case of inflation: lessor gets a fixed amount of lease rental every year and they cannot increase this even if the cost of the asset goes up.

2. To the Lessee:

• Ownership: the lessee will not become the owner of the asset at the end of the lease agreement unless he decides to purchase it.
• Compulsion: finance lease is non-cancellable and even if a company does not want to use the asset, the lessee is required to pay the lease rentals.