Here are some of the common pitfalls in equipment leasing and how a trusted leasing partner can help customers to understand and overcome them.
The Value of a Trusted Leasing Partner
Business professionals that are tasked with decision making and coordinating large asset purchasing are vital to any organization. With this huge responsibility there is great benefit to considering early in the purchasing process not just WHAT will be purchased, but HOW it will ultimately be paid for – especially when cash is not readily available.
For many equipment buyers, financing too often is considered only after decisions have been made on what is to be purchased. If too little attention is given to financing, decisions can be made too hastily and without the proper amount of scrutiny they warrant. Long after equipment is delivered and installed, the impact of financing arrangements (positive or negative) will linger, so a sufficient amount of care should be given to such an important aspect of any equipment acquisition decision.
An equipment lease of any size can be a significant commitment for a lessee (the entity renting or leasing the asset) with plenty of unknowns and potential risks – many of which can be difficult to understand or even detect. Some lessors (owner of the asset and the entity administering the lease) may even include subtle or intentionally vague language in their lease contract aimed at enhancing their own yield at a customer’s expense.
Managers focused on equipment acquisition may not be familiar enough with leasing to know that hidden costs and pitfalls exist, so it is advantageous for them to identify and work with a reliable leasing partner. To be such a partner, a lessor must, at a minimum, understand an organization’s needs and expectations and be ever ready to present fair, and honest leasing solutions to them. Once identified, a trusted leasing advisor can assist the buyer in the evaluation of lease pricing, structures, contract language, pitfalls to be aware of, and become a much more powerful and beneficial tool to any organization’s purchasing practices.
Even if a buyer/lessee uses an RFP process, or regularly obtains quotes from several lessors, a solid leasing advisor can serve as a go-to consultant to the buyer even if they are not ultimately the buyer’s lessor of choice. The leasing advisor can properly guide a buyer through potentially concerning items within any lease they may be considering and offer an alternative solution if/when needed.
If left unnoticed, hidden costs will make a seemingly impressive lease rate unimpressive very quickly, so the time to review and identify potential pitfalls is during the negotiation and certainly before any contracts are signed and bargaining power is lost.
For an equipment buyer considering leasing, naturally the goal is to get the best deal possible. When comparing several lease quotes then, likely the quote with the lowest monthly payment will get top consideration and why wouldn’t it? Logically, the lowest quoted payment will mean the least amount of money spent by the lessee on the transaction, so it must be the “best deal”-- but it may not be. Whether it’s a one-time equipment lease or part of an organization’s equipment acquisition strategy, there are many things to be aware of beyond just payment and interest rates.
Often, a low-rate lessor makes up their yield from a customer either throughout the lease or at the end of a lease. When such additional charges are factored into the lessee’s overall costs, they may discover they’ve paid more and sometimes much more with the “low rate” choice than they would have with what appeared in the beginning to be a more expensive option. A lessor that quotes a higher payment is not necessarily more expensive overall, they might have simpler documentation and less of a tendency to include additional charges within their contract. The only way for a buyer to determine their best choice is to carefully review and understand each lease contract before making a final decision.
Here is an overview of some of the most common hidden costs and pitfalls used in the leasing industry:
If a payment seems unrealistically low, a wise buyer will look deeper by reviewing the lease document thoroughly. Excessively wordy and/or unclear contract language may indicate a lessor’s attempt to deliberately exploit a lessee’s lack of experience or understanding of lease contracts. A buyer should not proceed without a reasonable understanding of the meaning and intent of the terms and conditions in a lease contract. Furthermore, if a lessor is unwilling or unable to explain or negotiate their terms and conditions, a buyer should proceed with caution. A fair lessor that has nothing to hide will be willing to, in good-faith, discuss, explain, and negotiate items within their agreement that are unclear or even risky in the eyes of the potential lessee.
Additional Fees – Beyond the Monthly Payment:
Fees are commonplace in the consumer world. Buy an event ticket, pay a “processing fee.” What about airline baggage fees or hotel “tourist” fees? Sometimes these fees are clearly stated or even expected by the consumer, but other times they are revealed only when it’s too late to contest or they are simply part of the “price of admission.” Fees figure prominently in other lending transactions like mortgages, business loans and car leases, but aren’t necessarily as commonly accepted with equipment leases in some business sectors.
Fees added to equipment leases improve the lessor’s yield at the lessee’s expense. Importantly, fees associated with equipment leasing are typically and intentionally not factored into the quoted interest rate, so they do not have a direct or perceived direct impact on the customer’s quoted lease rate. Using this approach, a lessor can enhance their yield on the lease while still showing the customer an attractive rate.
Fees that may be included in an equipment lease:
- Application Fee – This is a charge just for applying for a lease and is said to cover the lessor’s cost of reviewing and processing a lessee’s application. It varies widely in price, but can be as much as $1,000! This might be the most excessive charge a lessee could face. This fee may also appear as a type of non-refundable deposit. Application fees are an unnecessary cost that a lessee should not have to pay.
- Origination Fee: An upfront fee charged for processing a new loan or lease application, used as compensation for putting the deal in place. Amount is typically 1% of the total equipment cost.
- Commitment Fee: a charge simply based on a lender or lessor’s commitment to lend credit to a lessee.
- UCC (Uniform Commercial Code) Filing Fee: A UCC-1 is a legal form that a lessor files to give legal notice to the state where the lessee resides that it has interest in or claim to an asset being used by a lessee. The filing cost varies by state and while it is nominal, some lessors bill the lessee for it.
- Document Preparation Fee: This fee covers the supposed costs associated with the preparation of lease/loan documents.
- Processing Fee: A fee of a few hundred dollars that covers the cost of processing a loan or lease.
In the overall consideration of an equipment lease, some of these extra costs may not be enough to sour a potential lessee, but why should they be required to cover the lessor’s minor operational costs? Some of these charges may not even show up until after the lessee has committed to the low rate and attractive monthly payment.
When a lessor is chosen on the merits of payment or rate only, it is wise for a buyer to confirm prior to signing the final document, any other costs that may be included beyond the quoted payment. This way, a lessor can see whether their all-in costs are genuinely low compared to other bids. If fees are made clear at the outset, a lessee can then make a more informed decision. When everything is on the table, a simple calculation and careful review of the low-rate option may in the end expose it as a more expensive option.
Lease Deposit (AKA First/Last Payment Due Up Front):
Lease deposits are quite common in equipment leasing and are not necessarily a bad thing if done fairly and transparently – meaning the deposit should be applied to or deducted from the principal. If a lease includes a deposit, a lessee will want to look closely at how it impacts their quoted rate. If the equivalent of two monthly payments are required as a down payment and the quoted rate is 5% for 60 months, here’s how the down payment will impact that 5% rate: with two payments due up-front, the actual rate becomes 5.25%. If the lease deposit is not counted as the first monthly lease payment, then the actual rate inflates to over 8%!
A lease deposit is not mandatory – especially if a customer’s credit is solid. It’s just a way to enhance a lessor’s up-front yield on a transaction. If this is being required and more importantly, if an artificially low rate is hidden within it, a lessee should push back to see if it can be waived. If a lessor is not willing to waive it, perhaps an alternative lessor would do so.
Advance vs. Arrears Billing and Late Fees:
Late fee provisions are pretty standard in lease contracts and seemingly easy to understand. It should be safe to assume that late charges will never come into play for a lessee that plans to always pay on time. That’s a safe assumption IF they clearly understand when billing will occur. If the lessor is billing in advance (payment owed the month prior to equipment use) vs. arrears (payment owed on the current month of equipment use), this small detail could easily trigger a late charge the lessee never saw coming.
How flexible and/or forgiving is the lessor in the event of a late charge? Some are notoriously rigid and inflexible, so regardless of how unclear or unfair it may seem, the lessee will be stuck with it. Late fees are generally around 5% of a monthly payment but can be as high as 10%. While some lessors are fair, flexible and forgiving on enforcement, others are not and may even impose late fees if a customer is only one day late! A grace period and even a notification may be non-existent. Onerous late fees are a quick way for a low-rate lessor to recapture low yield at a lessee’s expense once the deal is signed.
Early Payoff Penalties:
Many leasing companies have prepayment penalties. In a contract it may be referred to as a “yield maintenance clause.” Sometimes the prepayment penalty is a fixed percent of the total lease amount that decreases as the lease progresses (5% in year one, 4% in year two, etc.). The most excessive form of prepayment penalties is when a lessee is contractually required to pay the sum of all future payments in order to pay off the lease. This means the lessee must pay all future projected finance charges and principal payments even if they pay the lease off early! Prepayment penalties can add 20-30% more to a customer’s total payment obligation on a lease. So care should be taken to understand early payoff penalties before a lease contract is signed. A customer should be especially wary of “sum of all future payments” prepayment language in a lease contract. If a lease contract includes such language, an astute lessee will be better off to pay the lease to the end rather than incur unnecessary charges by paying it off early.
Interim Interest Charges:
This is typically administered as a daily charge for the use of equipment from the time it is accepted by a lessee to the actual start date. The charge is based on the monthly payment divided by a 30-day month, then multiplied by the number of days between acceptance and start date). Some lessors intentionally delay the start date in order to maximize the interim rent they can charge a lessee.
A lessee’s obligation to begin making payments should normally begin on the date equipment is installed and goes “live.” This start date is usually referred to as the “commencement” date and it also signals or authorizes the lessor to pay the equipment vendor. Too often though, lessors include a second date in the contract that specifies when the lease payments will actually begin such as the first day of the month following commencement or customer acceptance. When this is done, the lessee is intentionally charged an additional “rent” amount for the “interim” between the two dates. Interim rent is really just extra interest that is charged to the customer as a deliberate yield enhancement for a lessor.
As an example, suppose a lessee agrees to a 60-month FMV lease for equipment valued at $100,000 with a lease payment of $1,770.00/month. That payment equates to an Annual Percentage Rate (APR) of 2.39%. If equipment is delivered and accepted by a lessee on the 10th of the month, but their lease doesn’t start until the beginning of the next month, they will pay 20 days of interim rent (i.e. interest) calculated as $1,770 divided by 30 days which equals $59.00 per day or $1,180.00 in total. With a 20-day interim period, it gets very close to a 61-month lease rather than the 60-month term the lessee agreed to and increases the overall lease rate by nearly .50%.
Interim rent is one of the most common yield enhancers used by lessors and one of the biggest “gotchas” in the leasing industry.
Leases that are not structured as a $1.00 buyout typically include three end-of-term options: (a) purchase the equipment (pre-defined amount or “fair market value”) (b) renew or extend the lease term, or (c) return the equipment. Variables that might complicate this process are the way a lessor defines or more importantly administers fair market value, bargain purchase options, renewal/extension payments, and notification requirements. A customer considering leasing should be careful not to be too taken with a low up-front payment while neglecting lease end considerations.
Lessors make money on the back end of equipment leases by baiting a customer with a low payment, then carefully and intentionally crafting the language in their lease document to their advantage. In short, if a customer’s rate is dramatically low at the beginning of a lease, the lessor will almost certainly make up the difference in the end and sometimes egregiously so. To guard against confusion and pitfalls, lessees should gain a clear understanding of the end-of-term options and treatment before ever signing a lease contract. Here are a few considerations for each of the three end of term options:
If the exact purchase amount is not defined on the lease document (i.e., a $1.00 buyout / 10% of original equipment cost), the document should clearly establish a process for defining the customer’s purchase price. The Fair Market Value is the price that a willing seller and a willing buyer agree to in an open market on an as-is, where-is basis, so the process should address any disagreement between the lessee and the lessor regarding that final value. If the two parties cannot agree on the purchase price, the contract should guide the parties to engage a qualified independent appraiser to provide additional guidance. Appraisal costs ideally are to be shared equally by both parties. A reasonable Fair Market Value should not contain language referring to the “in place, in use” equipment value as it only adds uncontrollable variables to the customer’s detriment and the lessor’s advantage.
- Renewal and notification:
In most cases when a customer elects for an extension or renewal of their lease term, the monthly payment does not change. A lessee is certainly within their rights though, to negotiate with a lessor to decrease the payment during any extension period.
If a customer does not plan on a renewal option and does not notify the lessor of their intentions as specified in the lease contract, they may find themselves paying for the equipment many times over due to what is commonly referred to as “evergreen” language.
- Evergreen Provisions:
Almost universally in the leasing industry, the onus is on the lessee to notify the lessor prior to the maturity of a lease of their intent to payoff, return, or extend a lease. The notification process is generally accepted by all involved. The way lease contracts define and dictate when customer notification must be given and what happens if notification is not given is what can cause trouble for a lessee. Typically leases specify notification at 90-180 days prior to lease maturity. When that notice is not given in writing at or before the time noted in the lease document, most contracts automatically renew. Lease contract language regarding renewal varies widely between lessors. Some lessors renew on a month-to-month basis and on the other extreme, others extend a lease out as long as the original lease term and beyond. Careful and intentional use of automatic renewals by lessors explains how a 36-month lease can last 4 years, or even 6 years! After several years of making lease payments, a lessee may understandably forget to provide this important end-of-lease notification and it can put the lessee in a difficult position if their lessor refuses to be flexible or forgiving on communication regarding their end of term intentions.
- Return of Equipment:
Some lease contracts may intentionally attempt to create impossible return standards in order to induce a lessee into paying an above-market purchase price for the equipment. A customer-friendly lease contract will to the extent possible: (a) Limit return shipping distances, (b) Allow return conditions to include “like-kind substitutions,” (c) Not include language requiring equipment to be returned in its original packaging, (d) If equipment can be self-maintained or has a warranty that extends throughout the life of the lease, request that no additional maintenance agreement be maintained, (e) If included at all, keep restocking fees to a reasonable minimum. Some lease contracts include restocking fees for returned equipment regardless of equipment condition.
An "all-but-not-less-than-all" provision in a lease agreement allows a lessor to continue charging full rent until every piece of equipment in a lease equipment schedule (as defined in the lease agreement) is returned. This provision is not always practical or even possible depending on the type of asset being leased. When this language is present in an agreement, a potential lessee should consider carefully its ability to return at lease maturity, all hardware and accessories that are listed on the lease agreement. If that seems impossible to fulfill, a customer should seek to negotiate terms that don’t place them in a disadvantaged position if "all-but-not-less-than-all" can’t be achieved. "All-or-any" language allows for partial return and substitution clauses ("like-for-like") for replacement of equipment can limit a lessee’s risk, but they too should be examined closely. Substitution clauses are often confining and require the replacement equipment to be of greater value.
If a lessee chooses to return equipment at the end of a lease, or any subsequent renewal, the process should be fair and reasonable. While it’s reasonable for a lessor to expect equipment to be returned in good working order with allowances for normal wear and tear, some lease contracts require that equipment be returned in “like-new” condition, which can require expensive refurbishment before it can be returned.
The language in a contract, however clearly defined and/or comprehensive as it may be, does not and should not supersede a lessor’s fundamental commitment to its customer. And yet, too often the strict enforcement of a contract – especially with regard to evergreen treatment, prevails over taking good care of what should be a valued customer. If handled carefully and correctly, it is possible for both sides to win rather than a customer having a negative experience with a lessor and then shying away from equipment leasing completely the next time it may be needed.
Ambiguity can be found within what should be one of the most clearly defined parts of any payment contract – the payment due date. Most contracts are clear about when a payment is due – (usually monthly), but troubling wording to watch for is a contract that includes the term “monthly equivalent payment.” This means the lessor plans for the lessee to pay quarterly in advance and results in costing a customer more than anticipated. It can also cause major issues with budget and cash flow projections.
Prompt Vendor Payment:
If a lessor chooses not to pay a vendor in a timely manner or needlessly delays paying an invoice when all requirements have been met to do so, it can damage a customer’s relationship with its supplier. The last thing any equipment buyer wants is a vendor putting them on credit hold or withholding consumables or services because their lessor is not paying the vendor appropriately. Some lessors have been known to needlessly delay payment to vendors due to “missing paperwork” or by using other delaying tactics or excuses. When a leasing company is selected, care should be taken to ensure that they are committed or even obligated to follow all negotiated vendor payment terms. If the selection process is part of an RFP, it should be clearly defined that vendor late payment penalties due to unnecessary lessor delays are the responsibility of the leasing company. Equipment buyers should not jeopardize future vendor relationships over a lessor that does not pay in a timely manner.
Independent Lessors vs. Captive Lessors:
When a buyer is considering an equipment purchase, it is certainly in their best interest if their potential equipment vendor provides a lease rate, a payment quote, or at a minimum, offers a referral to a leasing source as part of the equipment proposal. Even if a customer is inclined to purchase outright, it always helps to proactively create awareness that there are other acquisition options if they lack capital.
Some equipment vendors may pre-emptively provide a leasing option to a buyer that comes from a source sponsored by their company. This direct leasing option is referred to as a captive lessor. Many manufacturers have captive lessors and some sales people may even make a commission from “selling” the captive lease program. While there are certainly advantages to using a captive solution, they are not necessarily the best lease option. It may be sold as the best deal, the best rate or the most convenient solution for a buyer/lessee, but before a hasty commitment is made, a few questions should be asked:
- Is a captive lesor more flexible than an independent lessor alternative? Customers may think (or be told) that if they use the vendor’s company they will have more flexibility to upgrade or get out of the lease. In reality though, very few equipment companies have their own lessor. Most often they are partnering with a third party bank-owned or independent lessor using a dba. Given this, the lessor doing business as the vendor will have restrictions on cancellation or upgrades just as any other leasing company would.
- Is a captive lessor impartial? Many vendor lessors, be it in-house or third party, will give preferential treatment to their equipment partners when the lease is over and the time to upgrade has come. Their flexibility and impartiality ends if a lessor decides to change equipment vendors at lease maturity. Additionally, a captive lessor’s contract may even require a predefined lease acceptance, regardless of when the equipment becomes available for use!
- Is a captive lessor more competitive? It’s likely they will promote the convenience of being the “preferred lease vendor,” so the lease rate and payment presented may not be as competitive in the marketplace as a customer might think. A lessor that is tied in with a vendor may likely work closely to make internal adjustments to equipment pricing internally to ensure that their deal appears to be the most appealing to the customer. A lessee will never be aware of these “back room” adjustments, but it may sway a customer in their favor and cause them to view their deal as the best price even if that is not the case. By so doing, they will take the lessee’s focus off of some of the other hidden costs that could be lurking furtively within their lease document. If the option presented by a captive lessor is drastically lower than other options, it is wise to examine their contract closely to avoid other potential pitfalls.
When working with a captive lessor, it never hurts to also get a quote from an independent third-party lessor. Doing so will do one of three things: a) Validate a decision to go with vendor financing, b) Provide “ammo” to get a more competitive rate from the vendor finance company, or c) Lead to a better leasing solution from an independent lessor.
At the end of the day, what truly matters is not whether the lessor is a captive or an independent; it is what terms they can offer. Due-diligence should always be done by any institution offering financing terms and it is always worth the time it takes to seek out and review more than one option.
The ability to lease equipment is a powerful and enabling tool for equipment buyers. Knowing that pitfalls exist, buyers should evaluate leasing solutions with their eyes wide open and arm themselves with the proper knowledge and expertise that can minimize unnecessary or hidden costs. Proper management of equipment leasing may even justify obtaining added attention by outside professionals that have the knowledge and experience to understand and mitigate potential risks and build a smart leasing strategy for the buyer's organization. A wise decision maker will do well to identify a trusted and reliable lessor that best represents their organization’s interests, needs and priorities.