What is a finance lease & how does it work?What are the pros and cons of a finance lease?
A finance lease is a method of financing a vehicle that is usually accessed by VAT-registered businesses and companies, however sole traders and partnerships can also take advantage of finance lease. It is a form of car finance where the vehicle remains the property of the finance company, with the vehicle effectively hired out to a business. The business can then use this asset while paying an effective rental rather than a repayment.
Finance lease differs from contract hire in that you usually ‘balloon payment’ at the end of your lease agreement which pays off the leasing company’s investment. You agree how much your balloon payment will be, depending on whether you want higher or lower monthly payments during the lease agreement.
The exact monthly rental is determined by the initial cost of the vehicle, the period of the finance lease, the residual value, and that end balloon payment (not necessarily the vehicle’s residual value). As a residual value is used to calculate your monthly rental, most finance lease companies will insist that you stick to a strict mileage limit as this mileage restriction is used to determine the future value.
You have full use of the vehicle during the finance lease period. At the end of the finance lease agreement the vehicle is sold to a third party by the finance company, if the sold price is above the pre-determined balloon payment then the finance company will refund a percentage of the proceeds back to the hirer, if the sale price is below the balloon payment then the hirer will be liable to make a further payment to the finance company. This way, a company with a finance lease agreement shares more of the risk of the vehicle but can also potentially profit if the car exceeds its RV, than if they took a contract hire deal.
Alternatively you can agree to lease the vehicle again for a further period if you don’t wish to see it sold.
There are numerous benefits to acquiring a finance lease. These include:
Low monthly costs and initial outlay – One of the main reasons why companies take on
finance leases is to avoid the initial hefty outlay.
Flexibility – Most finance lease companies will offer a number of payment options to suit your cash flow. You can make deferred payments, lowering the monthly rental with a balloon payment at the end of the contract, or you can pay the entire cost in monthly installments.
Latest vehicles – You can gain access to the latest vehicles that would otherwise be affordable.
VAT payments – Up to 50% of the VAT payments can be reclaimed.
Balance sheet – Taking out a finance lease allows you to feature the vehicle on your balance
sheet, and outstanding rentals are represented as a liability.
Hire rental tax allowances can be applied for.
Sales proceeds – You can boost your equity by receiving a proportion of the sale at the end of the finance lease term.
There are disadvantages to finance leases too. Primarily these are that you will never take ownership of the vehicle as the car or van must be sold to a third party. A further disadvantage is that the hirer also takes on the administration and operating risk associated with the vehicle, including the road fund licence.
Furthermore, interest rates can vary steeply from company to company and unless you’re savvy you could pay out much more than you need to. Be prepared to shop around for the best deals. Also watch out for unexpected fees including documentation fees, which are paid at the outset and additional charges from the finance lease company.