A finance lease is a type of equipment lease where the customer (or 'lessee') rents an asset for most of the item's useful life. Finance leases are sometimes also known as capital leases.
Finance leases explained
One key feature of finance leases is that the customer takes on most of the risks and rewards of ownership (i.e. maintenance costs and fluctuations in value), but never actually owns the asset.
What this means in practice is that a finance lease looks and feels a lot like hire purchase, but they're different on the balance sheet.
How do finance leases work?
Finance leases consist of a primary rental period, where the monthly payments will add up to the full cost of the asset plus interest (hence their other name, capital leases).
Once the primary period is up, the asset will normally be near the end of its useful life. At the end of the primary lease period, you will usually have three options:
Continue to use the asset in a secondary lease period (often with cheaper payments).
Sell the asset and keep a share of income from the sale.
Return the asset to the lessor.
Finance lease or hire purchase?
For many businesses, choosing between a hire purchase and a finance lease comes down to financials and accounting. With hire purchase, you normally have to pay the VAT up front, whereas with a finance lease you can spread the cost of VAT over the monthly payments.
Some companies choose hire purchase because the asset shows on their balance sheet.
Others would prefer to show an asset as an operating cost and offset rentals against profit, and so would choose a finance lease.
Another important thing to note about finance leases is that the lease period will be for most of the asset's useful life — so it's normally more of a long-term commitment compared to operating leases.
Finance leases and capital leases: summary
Looks and feels a lot like hire purchase.
You won’t own the asset at the end of the contract.
Asset may or may not appear on balance sheet.
Term is for most of the asset’s useful life.
Risks and rewards of ownership.
Offset rental charges against profits and claim VAT.
May be able to sell the asset and get a rebate for remaining rental charges.