The rent, lease, buy decision is complex and usually involves juggling information on the purchase price, loan interest rates, lease/rental charges, tax consequences, and resale value of the equipment. Nothing can replace a detailed assessment of each business’s situation. Furthermore, a simplified decision-making template might not take into consideration all of your individual business needs or circumstances. Nonetheless, this article provides a three-step screening tool that can help you make a choice among renting, leasing, or buying your equipment.
When you buy equipment, you own it. As the owner, there are no limits on the use of the equipment or the length of time you own it. You can purchase the equipment with cash or finance part of the purchase price through your bank or other lending institution. Finally, when you no longer need your equipment, or wish to replace it, you can sell it for its resale value. On the other hand, depending on the age and condition of the equipment, you may incur a cost to get rid of it.
A lease and a rental agreement are contracts between you and the owner of the equipment. From a legal perspective, a lease agreement and a rental agreement are the same. A rental agreement typically has a term of less than one year (i.e., days, weeks, or months), while a lease’s term is usually for one or more years. The cost of maintenance is almost always included in a rental agreement (the renter does not have to pay extra for maintenance costs). Some companies offer leases that include routine maintenance, insurance, taxes, and other costs as part of the lease payment, but a more traditional lease requires you, as lessee, to pay for these costs during the term of the lease. A lease may also provide a purchase option at the end of the lease term.
The type of lease considered in this article has the following attributes:
- maintenance and other costs are paid for by the lessee and are not included in the lease payment,
- the lessee does not have a purchase option, and
- the lessee must return the equipment to the lessor at the end of the lease.
For example, a “net operating lease” satisfies these conditions.
There are also tax differences between buying and leasing or renting. Lease or rental payments may be deductible business expenses in the year they are incurred. When you buy and own equipment, your business may be entitled to deduct a depreciation expense. If you finance your purchase, then interest payments on the loan are considered business expenses for tax purposes. Your ability to take full advantage of these tax deductions depends on the profitability of your business.
To identify your best option among renting, leasing, or buying, answer the questions in the three decision trees in the following order:
Step 1: Renting Decision Tree
Step 2: Leasing Decision Tree
Step 3: Buying Decision Tree
A decision tree is read from top to bottom. The first step will help you determine if renting is appropriate.
For the Renting Decision Tree, the first question to ask yourself is: Do I expect to use the equipment for more than one year?
Remember that the rental option only meets a short-term need. Therefore, if the answer to this question is NO, then renting is most likely a proper choice and should be seriously considered. Since the benefits of renting decrease rapidly as the length of the rental term increases, if you expect to use the equipment for more than six months, compare the cost of a rental agreement to a one-year lease. You might find the one-year lease more attractive.
If you expect to use the equipment for more than one year, ask yourself the following: Do I know the type of equipment that is best for my business?
If the answer is NO, then consider renting as a means of testing certain models and types of equipment. After you decide on the type of equipment you want, decide whether you want to lease or buy the equipment. Renting equipment to determine your needs, however, can be expensive and should only be considered if the benefit of a more informed decision is worth the rental cost.
If you expect to use the equipment for more than one year and you know the type of equipment you want, then renting is not for you.
If you have decided that renting is not for you, go to Step 2: Leasing Decision Tree to determine if leasing is your best option. The first question to ask yourself is: Can I financially qualify for a lease?
This is a threshold question. Assuming your business is sound, if the answer is NO, go to Step 3: Buying Decision Tree. Typically you will be financially qualified for an equipment lease if you can qualify for a 100% loan to purchase the equipment.
If you are financially qualified for a lease, then ask yourself: Do I expect the equipment to have unusually high usage or excessive wear and tear?
If the answer to this question is YES, then leasing might not be your best option. Buying might be your best choice because you will expose yourself to unknown extra costs at the end of the lease term if the equipment has excessive usage or wear and tear. To determine what “unusually high usage or excessive wear and tear” means, take a close look at the lease to determine the maximum mileage, hours of operation, or condition the equipment must be in when you return it to the owner at the end of the lease term. If you think you cannot meet these requirements, then answer YES for this question.
If you do not expect unusually high usage or excessive wear and tear, the ask the following: Do I desire off-balance sheet financing? (Do I want to avoid additional debt or save my borrowing power for other transactions?)
If the answer to this question is YES and you do not have the cash to purchase the equipment, then leasing may be a good choice for you. One of the advantages of a lease is that it is often not considered a debt. The terms of the lease, price in particular, will dictate whether a lease is actually your best choice. Because of tax considerations for the owner (i.e., lessor) and other market conditions, the cost of a lease is dependent upon the time of year it is signed. Typically, you can get your best lease rates in the last quarter of the year.
If you do not have a strong need for off-balance sheet financing, or you have enough cash to purchase the equipment, then ask yourself: Do I expect to use the equipment for only one or two years?
If the answer is YES, then leasing might be a highly attractive option. One- or two-year leases are likely to be attractive because the resale value of equipment often drops rapidly in the early years, and you will most likely not be able to take full advantage of the tax benefits of ownership. Unfortunately, a definitive statement of the benefits of leasing under these circumstances is not possible because the decision will still depend on the relative cost of the lease.
Although leasing might still be an attractive option for your business, if you expect to use the equipment for more than two years, go to Step 3: Buying Decision Tree.
Use the Buying Decision Tree to determine if buying is your best option. The first question to ask yourself is the threshold question: Do I have the cash or borrowing power to purchase the equipment?
Again, assuming your business is financially sound, the inability to either pay cash or borrow the necessary funds to buy the equipment indicates that you should look at less expensive equipment or buying used equipment. Most likely if you are not qualified to borrow funds to finance the purchase of the equipment you desire, you will not be financially qualified to lease the equipment. Therefore, you need to consider less expensive options.
As a general rule, the less frequently you turn over your equipment, the more likely the buy decision will be right for you. So ask yourself the following: Do I expect to use the equipment for more than seven years?
If the answer is YES, then buying is your best option, because most leases have terms of seven years or less. The economic advantages of leasing diminish as the term of the lease increases. Therefore, if you do not expect to use the equipment for more than seven years, then ask yourself: Do I expect to use the equipment for five to seven years?
If the answer is YES, ask yourself: Do I have a strong desire to own the equipment I use and can I take full advantage of the depreciation and interest tax deductions?
If the answer is YES, then the buy decision makes sense for you. That is, if you have the ability to purchase the equipment, intend to own it for five to seven years, can use the available tax deductions, and have a strong desire to own the equipment, then buying it is your best decision. As the owner, you will also have more flexibility with the way you use the equipment and how long you will keep it.
If you intend to use the equipment for less than seven years, cannot use all of the tax deductions of ownership, or do not have a strong desire to own the equipment, then a more detailed after-tax cost comparison between the cost of leasing and buying is required before you can make a reasoned decision.
Following this three-step process might lead to the likely choice for you or your business. However, there is a large gray area where simple rules of thumb, such as the ones used to develop these decision trees, are insufficient. For example, if you intend to use the equipment for only three to four years, even if you have a strong desire to own the equipment you use, the economic differences between leasing and buying could be significant, and you are encouraged to perform a more detailed analysis. Even if you intend to use the equipment for five to seven years, your business might have certain attributes, such as your tax situation, that make leasing more attractive than buying.
The proper way to analyze the lease-versus-buy decision is to compare your expected after-tax costs for each option on a total life cycle cost (i.e., net present value) basis. Furthermore, because the tax consequences of leasing or buying can be significant, you should consult your tax advisor before you make your final lease or buy decision.
Acknowledgement
Terry Dubowick, director, and Mike O’Neil, public relations, of Mack Leasing assisted in the preparation of this article. The opinions and suggestions presented in the article, however, are those of the author and might not represent the views of Mack Leasing. Cat Financial has a good primer on leasing on its Web site (http://caterpillar.com/services/shared/cat_financial), including a glossary of terms.
