Home / Farm Loans / Lease Vs. Buy

To Finance or Lease?

Q: We've been equipment shopping for our dairy operation. Many dealers ask if we'll need credit to purchase the equipment. When we respond that we're interested in the financing options available, they mention leasing as a financing alternative. I grew up on a conservative dairy farm and was taught ownership is the only secure way to do business. Why then is leasing so popular and why would I consider leasing the equipment?

A: Just as leasing has grown in consumer popularity for automobile purchases, more farmers and agribusinesses have turned to leasing as a means of financing equipment and facilities. In fact, leasing is the fastest growing type of agricultural financing today. Even so, it remains one of the most misunderstood financial products in the market. An old rule of thumb many farmers still use today is, "Buy what appreciates and lease what depreciates." This may not apply in all situations but it does point to some practical rules to follow in your decision-making process.

In general, assets that hold value over time are best financed through conventional loans, especially at the low interest rates available today. Land is a good example. On the other hand, rapidly depreciating assets are often leased. Consider the technological changes in dairy equipment over the years. A purchase made five years ago could be nearly obsolescent today. In this situation, by leasing the equipment over a five-year period you can match the expensing of the asset to its actual depreciation. Plus, a lease gives you the option to return the equipment to the lessor at lease maturity and replace it with the latest technology.

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Q: When my lender analyzes the lease payments versus payments on a conventional loan, why is the internal interest rate higher on the lease?

A: Remember - "A loan is a loan is a loan, and a lease is a product of its own." When you buy a piece of equipment, you may save income taxes as a result of the purchase. First, you may be able to expense up to 100 percent of the equipment cost under IRS Section 179 rules. Second, you may be able to use the 30 or 50 percent optional bonus depreciations rules. Third, you may elect to depreciate the equipment over seven years. The amount of depreciation is based on Internal Revenue Schedules that vary based on the time of the year you purchased the equipment. For example, in the first year of ownership your tax deduction could be as high as 10.71 percent of the equipment cost for depreciation. Lastly, you may be able to deduct the amount of interest you pay on the loan used to purchase the equipment. (If you elect an annual payment loan, you may not have interest expense as a deduction in the first year because the interest will be paid one year after the purchase date.)

With a properly structured lease, however, you may deduct the entire lease payment regardless of the time of the year you entered into the lease. A typical three-year lease payment with a 35 percent fixed purchase option may result in a tax deduction equal to 30 percent of the equipment cost in the year that you leased the equipment. Ask your accountant to help you determine the "after-tax" internal cost of the lease. At times you'll pay less on an after-tax basis for leased equipment than if it were purchased using a conventional loan.

Keep in mind, too, that a lease allows for the return of the equipment to the lessor instead of paying the fixed purchase option price at lease maturity. Also, because you do not own the leased equipment, you do not need to list the equipment or the lease debt on your financial statement (according to the generally accepted accounting rules).

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Q: I don't understand why some equipment manufacturers offer low lease payments and a large fixed purchase option. The total payments on this type of lease are much higher than what I'd pay to purchase the equipment using a conventional loan. Explain how this type of lease can be a good option for me.

A: You're correct regarding the total payments being higher when a large fixed purchase option is offered. Quite simply, the low lease payment option is made available because some farmers want to keep their hourly or per acre cost to a minimum.

This leads to another rule of thumb when it comes to financing and leasing, "The bigger the balloon payment, the larger the sum of the total payments."

The following example may help clarify. Let's first look at conventional financing. If you're purchasing a $70,000 piece of equipment on a three-year loan with a seven percent interest rate, you'll usually pay about 25 percent of the purchase price down. That leaves $52,500 to be repaid on a loan, with an annual payment of $20,005. Your total out-of-pocket cost would be:

Down payment	$17,500.00
3 payments @ $20,005	60,015.00
Total	$77,515.00

Your interest cost would be $7,515 for the three-year loan ($77,515 less the $70,000 equipment cost).

Now, if you lease the same item at $10,000 per year for three years and have a fixed purchase option of $52,000, your total cost would be:

3 lease payments @ $10,000	$30,000.00
Fixed Purchase Option	52,000.00
Total	$82,000.00

It would cost you $4,485 more to own the equipment if you leased it first and then paid the fixed purchase option at lease maturity than if you would have purchased it using the conventional financing.

On the other hand, if you selected a three-year lease with only a 20 percent fixed purchase option with an annual payment of $20,957, the total cost (if you elect to purchase the equipment) would be:

3 lease payments @ $20,957	$62,871.00
Fixed Purchase Option	14,000.00
Total	$76,871.00

In this example, your total cost to lease is less than the seven percent loan option. You may also deduct the $20,957 lease payment each year from your taxable income. The result will be savings on State, Federal and Social Security taxes.

In general, repaying more principal each year will reduce your internal cost to purchase or lease equipment. Making lower payments and deferring principal payment to the end of the loan or lease will result in a higher out-of-pocket cost for the equipment.

Consult with a lease specialist and your accountant to become more comfortable with leasing your next piece of equipment. If you have additional questions about this topic, or any other issues related to the business of farming, feel free to send an e-mail to tbooth@badgerlandfcs.com.

Written questions also may be submitted to:
Financial Matters
315 Broadway
P.O. Box 69
Baraboo, WI, 53913-0069

Ron Weier is Director of Trade Credit and Leasing for Badgerland Farm Credit Services in Lancaster, Wis. He has a background in agricultural finance and leasing. Ron graduated from the University of Wisconsin-Platteville in Industrial Technology and has 27 years of experience with Farm Credit Services.

Financing & Leasing Thumb Rules

• Buy what appreciates, lease what depreciates.
• A loan is a loan is a loan. A lease is a product of its own.
• The bigger the balloon payment, the larger the sum of the total payments.

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