Difference Between Finance Lease and Operating Lease

Difference Between Finance Lease and Operating Lease

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Updated on Feb 9, 2024 12:37 IST

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).

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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 

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.

Benchmark Finance Lease Operating Lease
What is it? A commercial contract in which the lessor allows the lessee to use an asset in favour of regular payments for a usually long period. A commercial contract in which the lessor allows the lessee to use an asset in favour of regular payments for a usually short period.
Duration It is a long-term contract It is a short-term contract
Owner Ownership is transferred to the lessee (owner of an asset that is rented or leased). Ownership remains with the lessor (legal owner of the asset).
This lease is also called Capital lease Rental lease
The risk of obsolescence lies on the part of the Lessee Lessor
Who takes care of or maintains the asset? Lessee Lessor
Cancellation of the lease Can only be done on the occurrence of a specific event. Can be done at any time.
In this lease, is the bargain purchase or purchasing option given? Yes. In this lease, the purchasing option is given. No. In this lease, no such option is given.

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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.

You can also explore: Difference Between Forward and Future Contract

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. If you have any queries related to finance lease vs. operating lease, feel free to send your query through the comment box. We will be happy to help!

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FAQs

What is the difference between financial 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).

Regarding the difference between financial lease and operating lease, in which one of these two does the lessee get a choice to buy the asset for a price less than the asset's fair market value?

In terms of the difference between financial lease and operating lease, in the finance lease, the lessee gets a choice to buy the asset for a price less than the asset's fair market value.

Regarding the difference between financial lease and operating lease, in which one of these two does the lessee take care of or maintain the asset?

In terms of difference between financial lease and operating lease, in the finance lease, the lessee takes care of or maintains the asset.

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