When you enter into an equipment lease, the lease will be structured as either an operating lease or a capital lease.
A capital lease will require you to purchase the asset at the end of the lease term for a predetermined purchase price of around $10.
With an operating lease, at least 10% of the principal amount must be outstanding at the end of the lease term.
Interest or cost of capital is paid on this amount during the lease term.
At the end of the lease, if the lessee wishes to purchase the asset, this outstanding balance plus whatever other fees or costs will need to be paid to complete the transaction.
This large payment amount at the end of an operating lease is a balloon payment.
Balloon payments are also not restricted to 10% and can be much higher depending on the asset being financed, the applicant, and lending and funding criteria of the leasing company.
A balloon payment can also be built into an equipment loan, but is more common with equipment leasing scenarios.
The main reason for getting a balloon payment arranged is for cash flow management purposes.
The more of the principal repayment of the asset that can be delayed, the better its going to be for the cash flow during the period of the lease.
Of course if the intention of the applicant is to acquire the asset at the end of the lease term, there will have to be a means by which to cover off the balloon amount to complete the transaction.
There are basically two ways to do this.
First, and most common, the business pays the balloon payment from its own cash resources.
Second, the balloon payment is refinanced into another lease or an equipment loan and repayment of this amount is now scheduled over a longer period of time.
Larger balloon payments are most common with assets that have a very long useful life.
Because the asset will depreciate much slower than the rate of the principal repayment, a structured balloon payment serves to provide the opportunity for debt repayment to occur over a longer period of time and reduce the build up of equity in the equipment which doesn’t do much for the business owner’s cash flow.
If you’d like to know more about balloon payments and what you may be able to qualify for, I suggest that you give us a call and we’ll go over your financing requirements with you and provide relevant financing options for your consideration.