What Is Finance Leasing?

Finance Leasing is a way of getting the use of a vehicle without taking ownership of it

Finance leasing is typically only used by businesses. Personal use of finance leasing is very unusual, though it can have advantages.

The leasing period (or 'term') is usually a number of months or years during which the vehicle is still owned by the leasing company (the 'lessor') but is rented to the user (the 'lessee').

Effectively the user is borrowing the vehicle from the lessor for a fixed period in return for a lease payment (or 'rental').

What Is In Finance Lease Rentals?

During the lease period the lessee pays a rental to the leasing company which covers the costs incurred by the lessor to buy the vehicle, plus a profit for the lessor.

In other words, the lessee pays for:

  • The full purchase price of the vehicle
  • Vehicle Excise Duty
  • Interest Charges on the money borrowed by the lessor to buy the vehicle on behalf of the lessee
  • The lessor's profit margin (which might be just the interest charges)
  • VAT
  • Maintenance (Optional)

At the end of the lease period the lessee normally returns the vehicle to the leasing company (though some leases may have a 'run-on' or 'secondary term' clause allowing the vehicle to continue under lease for much lower lease rentals).

At the end of the lease the leasing company disposes of the vehicle and pays the lessee a proportion of the sales value. This repayment is referred to as a 'rebate of rentals' and includes VAT on the amount paid back.

Amortisation and Leases

A finance lease is sometimes described as a 'fully amortised' finance product.

'Amortisation' is the process of writing off the cost of an item over a period of time. With fully amortised leases the whole of the purchase price of the vehicle is repaid to the finance company in stages over the finance period (the 'term').

At the end of the term there's nothing left to pay off the purchase price of the vehicle.

Because the lessee is repaying the full price of the vehicle during the term, as each monthly payment is made the lessee reduces the outstanding amount financed at a faster rate than in 'balloon' type leases, where the expected future value of the vehicle is left unpaid throughout the term of the lease.

Because more of the purchase price is repaid and is repaid quicker in a fully amortised finance lease than in balloon leases then, assuming interest rates are the same in both finance leases and balloon leases, the total interest charges in a fully amortised finance lease are less than those in a balloon lease or contract hire agreement.

This is because less money is left unpaid during the term.

As a result, the overall costs of finance for a fully amortised lease are lower than those of a balloon lease.

However, repaying a larger amount of the purchase price each month means that the actual monthly payments are higher in fully amortised leases than for a balloon lease.

Advantages of Finance Leasing

For passenger cars, because the leasing company recovers VAT on the purchase price of the vehicle, the rentals for passenger cars will be lower than comparable finance instalments for hire purchase (where VAT on the purchase price is not usually recoverable for a purchaser).

Because the vehicle is leased, the normal responsibilities of ownership, such as sourcing the best deal and obtaining the best resale value, may be avoided if the leasing company already has supply and disposal arrangements.

The lessee may also profit from prudent management of the vehicle, such as achieving a better resale price than expected and therefore a higher rebate of rentals.

Disadvantages of Finance Leasing

The lessee is normally at risk for the residual value of the vehicle at the end of the lease, so under accounting conventions applying at the date of publication, leasing must be disclosed on the balance sheet of a business as a liability. This status can worsen the appearance of the financial position of a business.

If the lease agreement is terminated earlier than expected then the lessee may be required to pay a penalty (usually a number of months rentals).

VAT incurred on the lease rentals cannot be recovered in full on passenger cars used for private purposes by employees - only 50% of the VAT incurred can be recovered.

Tax relief for the lessee on cars with a CO2 output over 110GP/Km is restricted (50GP/Km from April 2021), thereby increasing the total costs of leasing for cars with higher CO2 emissions.

Lease or Buy?

To see the cost impact of leasing or buying your next new car click here.

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