Finance or operating lease? Deciphering the legalese of equipment finance

April 04, 2024

What type of lease makes the most sense for financing equipment? Learn the legal language behind each major financing path and the common pitfalls to avoid.

New equipment is essential for the long-term success of a business, and the decisions around financing that equipment require many considerations. After all, there are two very different lease structures available for equipment financing: finance leases and operating leases. Each type brings its own set of benefits and conditions depending on various circumstances – like the duration of the lease or value of the property. But each path also comes with its own legal terminology to understand and pitfalls to avoid, making the initial decision to finance an equipment refresh the first of many complex choices. 

This article will decipher the nuances of the equipment financing process by outlining the characteristics of each lease type, identifying when each one is appropriate, and explaining the four most common pitfalls so your organization can choose the most suitable option and avoid running into problems down the line. 

Finance leases

Finance leases meet one or more of the following criteria and are classified as purchases by the lessee:

  • The lease term is greater than 75 percent of the property’s estimated economic life. 
  • The lease contains an option to purchase the property for less than fair market value. 
  • Ownership of the property is transferred to the lessee at the end of the lease term. 
  • The present value of the lease payments exceeds 90 percent of the fair market value of the property.

Note: This type of lease was also called a “Capital Lease” in the past. Under ASC-842 rule changes, the term “Capital Lease” is no longer used in the GAAP accounting classifications. 

 

Operating leases 

Operating leases are any leases that are not finance leases. Organizations generally use them for short-term equipment leasing. The lessee can acquire the use of equipment for just a fraction of the useful life of the asset, and the lessor may provide additional services such as maintenance and insurance.

Why would I choose an operating lease?

What do I need to know before signing an operating lease?

If you do not want to own your equipment or are simply looking for a short-term “right-to-use” agreement, then an operating lease might make more sense.  

Since you don’t own the equipment, you wouldn’t get tax depreciation benefits from asset ownership.

Life cycle management. Operating leases allow for more flexibility in upgrading or replacing equipment, especially to keep pace with a 3-5 year lifespan.

Lessors might offer an early buyout option and/or a fair market value purchase option at the end of the lease.

Operating lease accounting processes may be simpler, since lease payments are considered operating expenses.

Lessors may offer lease renewal options– and when you enter into an operating lease, your company may have the option of returning the equipment without further obligation.

Why would I choose an operating lease?

What do I need to know before signing an operating lease?

If you do not want to own your equipment or are simply looking for a short-term “right-to-use” agreement, then an operating lease might make more sense.  

Since you don’t own the equipment, you wouldn’t get tax depreciation benefits from asset ownership.

Life cycle management. Operating leases allow for more flexibility in upgrading or replacing equipment, especially to keep pace with a 3-5 year lifespan.

Lessors might offer an early buyout option and/or a fair market value purchase option at the end of the lease.

Operating lease accounting processes may be simpler, since lease payments are considered operating expenses.

Lessors may offer lease renewal options– and when you enter into an operating lease, your company may have the option of returning the equipment without further obligation.

Common pitfalls to avoid in the equipment financing process

Whether you pursue a finance or operating lease, there are several potential pitfalls that can be found in equipment lease contracts that might make things difficult for an organization down the line. 

Here are the four most common situations to avoid.

1. Vague end-of-lease term options

Everything in your leasing contract might look good at the start, but some funding sources might try to hide lessor preferential terms in the end-of-lease section. This could greatly cost your organization at the end of your lease, when your equipment is approaching its warrantied lifespan.

Address this concern by making sure that your end-of-term options in the proposal match those in the lease agreement and riders. Also ensure that, if desired, your company has the ability to return the equipment without further obligation at the end of the lease term.

You don’t want to be stuck with outdated technology – it would negate one of the largest benefits of leasing.

2. Artificially low base rates

Those zero percent financing offers may sound tempting, but it generally just means you’ll end up paying more over the long term. If it sounds too good to be true, look into the terms and find out where your vendor is basing those rates.

Zero percent financing from a vendor finance source may reflect an inflated asset cost.  

Clients can reconcile true costs by offering to pay with cash and use that sales price as the basis on which the finance rate will be based.

3. Software partners who don’t offer 100 percent financing options

Make sure that the financing source is willing to finance 100% of the asset value.  One of the common benefits of leasing in comparison to other forms of financing like bank debt is the ability to finance 100% of the asset cost. 

4. Those hidden, unspecified fees

Hidden fees buried in financing documents can trip up organizations, especially near the end of negotiations. Under the guise of “transaction fees” or something similar, these surcharges add to the total cost of leasing.

Some other common fees include:

  • Documentation 
  • Executory
  • Commitment
  • Restocking
  • Uniform Commercial Code (UCC) filing
  • Legal
  • Transactional
  • Service charges
  • Facility charges

These potential pitfalls found during the process of signing financing contract can be costly and add to the implicit borrowing cost. It's in your interest to address them before you sign anything. 

Choosing the right type of lease is vital to achieving your short-term and long-term business goals — and we can help you decipher the common phrasing used in equipment financing documents. Wherever you are in the discussion, we’re here to help you get the most effective solution.

Contact a U.S. Bank Equipment Finance specialist to discuss your unique situation.

Related content

6 tips for trust fund distribution to beneficiaries

Preparing for retirement: 8 steps to take

How to build wealth at any age

How to manage your money: 7 tips to improve your finances

LGBTQ+ financial planning tips

Investment strategies by age

Should I itemize my taxes?

Your 5-step guide to financial planning

6 things to know about long-term care insurance cost and benefits

What is Medicare? Understanding your coverage options

Want AP automation to pay both businesses and consumers?

Military homeownership: Your guide to resources, financing and more

Home buying myths: Realities of owning a home

5 financial goals for the new year

Retirement savings by age

Annual insurance policy review checklist

How I did it: Turned my side hustle into a full-time job

Retirement plan options for the self-employed

5 reasons why couples may have separate bank accounts

It's possible: 7 tips for breaking the spending cycle

Closing on a house checklist for buyers

How to plan and save for adoption and in vitro fertility treatment costs

Multiple accounts can make it easier to follow a monthly budget

Is it time to get a shared bank account with your partner?

Don’t underestimate the importance of balancing your checking account

7 steps to keep your personal and business finances separate

Which is better: Combining bank accounts before marriage — or after?

ABCs of APIs: Drive treasury efficiency with real-time connectivity

30-day adulting challenge: Financial wellness tasks to complete in a month

Estate planning checklist: 8 steps to secure your legacy

8 steps to choosing a health insurance plan

Key milestone ages as you near and start retirement

How I did it: Bought a home without a 20 percent down payment

What you need to know before buying a new or used car

Estate planning documents: Living trusts vs. will vs. living will

Why estate planning is important

How a Health Savings Account (HSA) can benefit your retirement plan

Year-end financial checklist

Leveraging the ASC-842 rule changes in equipment lease accounting

Blockchain: Separating hype from substance

The AI journey in finance: How to make it part of your strategy

ABL mythbusters: The truth about asset-based lending

Finance or operating lease? Deciphering the legalese of equipment finance

Buying or leasing? Questions to ask before signing a contract

Insource or outsource? 10 considerations

The secret to successful service provider integration

Colleges respond to student needs by offering digital payments

Drive digital transformation with payments innovation

Banking connectivity: Helping businesses deliver the easier, faster, more secure customer experience of the future

Automate accounts payable to optimize revenue and payments

Automate escheatment for accounts payable to save time and money

Addressing financial uncertainty in international business

Safeguarding the payment experience through contactless

COVID-19 safety recommendations: Are you ready to reopen?

3 ways to make practical use of real-time payments

How AI in treasury management is transforming finance

Unexpected cost savings may be hiding in your payment strategy

Digital trends poised to reshape hotel payments

Enhancing the patient experience through people-centered payments

Empowering managers with data automation and integration

What corporate treasurers need to know about Virtual Account Management

Treasury management innovations earn Model Bank awards

How to sell your business without emotions getting in the way

5 steps to take before transitioning your business

10 tips on how to run a successful family business

Streamline operations with all-in-one small business financial support

Talent acquisition 101: Building a small business dream team

Costs to consider when starting a business

How to test new business ideas

The costs of hiring a new employee

Small business growth: 6 strategies for scaling your business

Why ecommerce for small business strategy is integral

How to expand your business: Does a new location make sense?

How running a business that aligns with core values is paying off

Meet the Milwaukee businessman behind Funky Fresh Spring Rolls

How to build a content team

3 ways to gain loyalty with your customers

Multigenerational household financial planning strategies

Do I need a financial advisor?

How to track expenses

How to manage your finances when you're self-employed

Good debt vs. bad debt: Know the difference

Reviewing your beneficiaries: A 5-step guide

How to talk about money with your family

Financial steps to take after the death of a spouse

Retirement advice: How to retire happy

Retirement income planning: 4 steps to take

Preparing for retirement: 8 steps to take

Working after retirement: Factors to consider

4 steps to finding a charity to support

Year end tax planning tips

Tips for navigating a medical hardship when you’re unable to work

11 essential things to do before baby comes

Checklist: 10 questions to ask your home inspector

Resources for managing financial matters after an unexpected death

What you need to know as the executor of an estate

What documents do you need after a loved one dies?

How I did it: Paid off student loans

Bank Notes: College cost comparison

From LLC to S-corp: Choosing a small business entity

Uncover the cost: Wedding

Uncover the cost: International trip

Tips to overcome three common savings hurdles

Adulting 101: How to make a budget plan

Personal loans first-timer's guide: 7 questions to ask

3 awkward situations Zelle can help avoid

How can I help my student manage money?

Do you and your fiancé have compatible financial goals?

U.S. Bank asks: Transitioning out of college life? What’s next?

U.S. Bank asks: Do you know your finances?

Personal finance for teens can empower your child

How to save for a wedding

Here’s how to create a budget for yourself

9 simple ways to save

Dear Money Mentor: How do I set and track financial goals?

Lost job finance tips: What to do when you lose your job

Money Moments: 3 smart financial strategies when caring for aging parents

Money management guide to financial independence

Money Moments: 8 dos and don’ts for saving money in your 30s

7 financial questions to consider when changing jobs

Travel for less: Smart (not cheap) ways to spend less on your next trip

What’s in your emergency fund?

P2P payments make it easier to split the tab

What you need to know about renting

How to stop living paycheck to paycheck post-pay increase

Understanding guardianship and power of attorney in banking

What financial advice would you give your younger self?

How grandparents can contribute to college funds instead of buying gifts

How to open and invest in a 529 plan

Using 529 plans for K-12 tuition

Parent checklist: Preparing for college

What to consider before taking out a student loan

How to use debt to build wealth

For today's homebuyers, time and money are everything

Crypto + Homebuying: Impacts on the real estate market

Should you buy a house that’s still under construction?

House Hacks: How buying an investment property worked as my first home

Your guide to breaking the rental cycle

4 ways to free up your budget (and your life) with a smaller home

Money Moments: Tips for selling your home

First-time homebuyer’s guide to getting a mortgage

Dear Money Mentor: When should I refinance a mortgage?

Beyond the mortgage: Other costs for homeowners

10 ways to increase your home’s curb appeal

10 questions to ask when hiring a contractor

5 things to avoid that can devalue your home

Common questions about electric vehicles (EVs)

Car shopping: Buying versus leasing your next vehicle

Take the stress out of buying your teen a car

Questions to ask before buying a car

What you should know about buying a car

How to choose the best car loan for you

Disclosures

Start of disclosure content

Loan approval is subject to credit approval and program guidelines. Not all loan programs are available in all states for all loan amounts. Interest rate and program terms are subject to change without notice. Mortgage, Home Equity and Credit products are offered through U.S. Bank National Association. Deposit products are offered through U.S. Bank National Association. Member FDIC.