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What Is A Finance Lease?

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

The leasing period is usually a number of months or years during which the vehicle is still owned by the leasing company. Effectively the lessee (the person or company to whom the vehicle is leased) is borrowing the vehicle from the supplier for a fixed period in return for a lease payment.

What's In Finance Lease Rentals?

During the lease period the lessee pays a rental to the leasing company which covers the costs incurred by the leasing company to acquire the vehicle. In other words, the lessee pays for:

The full purchase price of the vehicle
Interest Charges
Profit Margin
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" clause allowing the vehicle to continue under lease for much lower lease rentals).

The leasing company then disposes of the vehicle and pays the lessee a proportion of the residual value obtained on the sale. This repayment is referred to as a rebate of rentals and includes VAT.

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 and 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 has repaid 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 such as contract hire, 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 then, assuming interest rates are the same in both fully amortised 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 (because less money is left unpaid during the term), so 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

Because the leasing company recovers VAT on the price of the vehicle the rentals for passenger cars will be lower than comparable finance instalments for hire purchase. Because the vehicle is leased, the normal responsibilities of ownership, such as sourcing the best deal and obtaining the best resale value, are avoided. The lessee may 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 110g/km is restricted, thereby increasing the total costs of leasing for cars with higher CO2 emissions.