Understanding Loan and Lease

Understanding Loan and Lease

November 7, 2020

Have you been or are in a situation you consider these two options but don’t know which one to go for? Or are you just seeking general knowledge on these topics?  By the end of this article, you would have a broad understanding on these topics.

Let’s first start with the definition of these terms;

A loan is an external source of funding wherein money is borrowed from another entity to fund any purchase or expense. Loans are generally taken from banks or financial institutions, but can also be obtained from any willing entity. There are various types of loans. Personal loans, credit card loans, home  loans, etc.

A lease is a contractual arrangement, whereby one party, the lessee, gets the right to use an asset from another party, the lessor, for a specified period (lease term) in return for periodic monetary payments across the lease term. There are various types of leases, but we have two general ones which are; Finance Lease and Operational lease.

  • Finance Lease: A finance lease is a lease that involves the lessee having the right to get ownership of the asset at the end of the lease term on payment of certain residual value.
  • Operational Lease: An operational lease is a lease whereby the ownership of the asset remains with the lessor and only the right of use vests with the lessee, similar to a rent arrangement.

Now let’s highlight some major differences between these two financial terms.

The person/business providing the funds is called the lender and person/business obtaining the funds is called the borrower.In case of a lease, the institution providing the asset is called the lessor and the person/business using the asset is called the lessee.
Interest on loans can be fixed or floating, wherein the case of floating rates, the rate of interest increases or decreases depending on the benchmark rates to which the floating rate is pegged.In general, the rates for a lease are fixed in nature instead of otherwise stated. It helps companies to make expense forecasting and budgeting.
Securing loans generally require the borrower to provide an asset as security or collateral, as guarantee for repayment of the loan, to the lender.There is no concept of providing security in case of a lease arrangement, other than the leased asset itself.
The process of documentation required is a bit lengthy and time taking in case of a loan as the loans are also taken by individuals.Lease is a simpler process as it just requires ascertainment of lessee’s need for the asset and ability to make lease payments.
For loan, the borrower obtains funds i.e. actual money.For lease, the lessee obtains right to use an asset.

In conclusion, though the concept of loan and lease is similar, there is a difference between these two concepts. While a loan is that situation where an individual or a business borrows money from a financial institution, lease refers to a contract between a lessor and lessee where the lessee uses the asset of the lessor for a specified time period but in return of periodic payments. A loan and a lease are both modes of aiding operations for a business. With assets, whether a business should avail a loan to purchase or whether it should obtain the asset on lease is guided by several business factors. Value of the asset, financial strength of the business term for which the asset is to be used, ability to provide collateral and repay are some important guiding factors.

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