What is a Financial Lease?

Also known as a capital lease, a financial lease is a situation in which a finance company or other lessor purchases an asset, then leases that asset to a client or lessee for a specified amount of time. At that point, the client takes possession of the asset and is free to utilize the asset for the duration of the lease agreement. Once the client has fulfilled the terms of the lease, including paying any applicable interest, the client usually has the option of purchasing the asset from the finance company at an extremely low price.

The exact duration of the financial lease will vary, based on the nature of the asset and the terms agreed upon by the client and the finance company. Some agreements of this type are set up as a long-term agreement, while others require an intermediate-term. For the life of the lease, the lessor retains ownership of the asset. The client has full use of the asset, and thus enjoys most of the benefits of ownership. However, the lessee also assumes many of the responsibilities associated with ownership, even though the lessor retains that status.

One of the easiest ways to understand how a financial lease functions is to consider non-cancelable lease agreement for a new vehicle. The lessor and the buyer or lessee agree that the lessee will lease the new vehicle for a series of payments, with one payment due each calendar month for the duration of the lease. During this period the lessor is still the owner of record, but the lessee is responsible for the maintenance and most repairs on the vehicle, other than those specifically addressed in the terms and conditions of the lease. At the end of the lease, the lessee has the option of buying the vehicle from the lessor, usually for very little, and becoming the full owner of the car.

This type of commercial arrangement is different from a similar agreement known as an operating lease. With an operating lease, the lessee has only limited access to the asset; with a financial lease, the lessee has complete use. In addition, the lessor usually recoups the full investment, plus a small return, over the life of the financial lease; that is not necessarily the case with an operational lease, where the lessor may still have an outstanding amount of investment that has not been recouped.

A capital or financial lease functions according to the regulations put in place in the jurisdiction where the agreement is established. Different nations set the criteria for what constitutes a lease of this type. In the United States, a capital lease must meet one of four basic qualifications. The lease must offer the option of transferring ownership to the lessee at the end of the lease; there must be a bargain purchase option that is less than the current fair market value of the asset. In addition, the duration of the lease must be at least equal to 75% of the anticipated useful life of the asset; and the total value of the lease payments must be at least 90% of the original amount paid by the lessor to acquire the asset.