Difference Between Finance Lease and Operating Lease

The main difference between finance lease and operating lease is that a finance lease is a long-term concept in which the ownership of the asset is transferred to the lessee (owner of an asset that is leased or rented). On the other hand, an operating lease is a short-term concept in which the ownership of the asset is not transferred and remains with the lessor (legal owner of the asset).

Understanding the distinction between financial lease and operating lease is crucial for businesses seeking to acquire assets through leasing. These two leasing options offer distinct benefits and implications, influencing financial strategies and operational decisions. A finance lease entails lessees assuming near-ownership responsibilities, while an operating lease provides more flexibility and less long-term commitment. Exploring these differences empowers businesses to select the most suitable leasing arrangement based on their specific needs, financial goals, and risk tolerance.

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Table of content

• Difference between finance lease and operating lease
• What is a finance lease?
• What is an operating lease?
• Key differences between finance lease and operating lease

Difference between Finance Lease and Operating Lease 

The terms “finance lease” and “operating lease” are so frequently confused that the key difference between the two is easily missed. So, to understand the difference between finance lease and operating lease better, let’s explore it in a tabular format.

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What is a Finance Lease? 

Finance lease definition: A finance lease is a long-term concept in which the ownership of the asset is transferred to the lessee (owner of an asset that is leased or rented). 

A finance lease is a commercial lease in which the lessee receives almost all of the risks and rewards of fixed asset ownership. In a finance lease, the lessee can purchase the asset for a price less than the asset’s fair market value.

To understand finance lease better, let’s go through an example. Suppose there are two people, A and B. Person A purchased a new car, and after some days, B asks him to rent the car for five years (finance lease). The terms of the finance lease will be something like this:

• The term will be decided as the useful life span of the asset, say five years,
• Then the rental amount will be decided, and all the risk/profit will belong to person B. (In this case, the damages, insurance, etc.)
• Person B pays the rental amount; at the end of the lease period, he can pay a balloon payment and keep the vehicle.

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What is an Operating Lease?

Operating lease definition: An operating lease is a short-term concept in which the ownership of the asset is not transferred and remains with the lessor (legal owner of the asset). 

In simple terms, in an operating lease contract, the right to use assets is given, but the right of ownership of an asset is not given. This lease is highly beneficial for individuals or businesses, mainly when a company does not require machines or assets for an extended period or when they want to replace their assets. In an operating lease, the lessee does not have the choice to purchase the asset for a price less than the asset’s fair market value.

To understand finance lease better, let’s go through an example. Suppose there are two people, A and B. Person A purchased a new car, and after some days, B asks him to rent the car for one month (operating lease). The terms of the operating lease will be something like this:

• Person B can use the vehicle for the duration of the agreement, paying monthly rental fees. (Note: These payments are not the same as the vehicle’s total value, as with a finance lease.)
• The risks remain with person A, and the vehicle will be returned to them at the end of the term.

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Key Differences Between a Finance Lease and Operating Lease

Here are the key differences between finance lease and operating lease:

• A finance lease is a long-term contract, whereas an operating lease is a short-term contract.
• In the finance lease, the ownership of the asset is transferred to the lessee. But, it not the case in the operating lease.
• In the finance lease, the lessee takes care of or maintains the asset, whereas, in the operating lease, the lessor takes care of or maintains the asset.
• In the finance lease, the lessee can buy the asset for a price less than the asset’s fair market value. On the other hand, in the operating lease, the lessee does not get a choice to buy the asset for a price less than the asset’s fair market value.

Conclusion

The main difference between finance lease and operating lease is that a finance lease is a long-term concept in which the ownership of the asset is transferred to the lessee (owner of an asset that is leased or rented). On the other hand, an operating lease is a short-term concept in which the ownership of the asset is not transferred and remains with the lessor (legal owner of the asset).

I hope that now that you know the difference between finance lease and operating lease, you will not get confused between these terms. 

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