The Lowest Equipment Payment Isn't Always the Best Financing Decision

When a business is evaluating equipment, the lowest scheduled payment can be appealing. Lower payments may help preserve cash, support seasonal operations or create more room for payroll, inventory and other commitments.

But payment size is only one part of the decision.

The financing structure should fit what the business is trying to accomplish with the equipment, how long it expects to keep it, how much of the equipment cost it wants to pay down during the term and what it wants to happen at the end.

That is why two proposals for the same equipment can have different payment amounts and very different end-of-term obligations.

The question is not simply, “Which option has the lowest payment?” It is, “What is this structure designed to accomplish?”

The economic meaning of a residual or purchase option

A residual represents an amount or a value associated with the equipment at the end of the regular term. Depending on the structure, leaving a meaningful residual can reduce the amount that must be recovered through the scheduled payments and may therefore reduce the scheduled payment.

A purchase option is the amount or method used to address the equipment at the end of the regular term. It may be a nominal amount, a defined percentage, or an amount based on the equipment's fair market value at that time.

Leaving a larger residual generally provides more payment relief during the term while leaving more to address at the end. A structure with little or no meaningful residual generally requires more of the equipment cost to be recovered during the regular term.

Neither approach is automatically better. The right choice depends on the business's cash flow, ownership plans and expected equipment life.

Four structures business owners may encounter

EFA, or equipment finance agreement

An equipment finance agreement is a financing agreement used to finance the purchase of equipment, generally secured by the equipment.

Economically, an EFA is designed for a business that expects to retain the equipment long term. The business makes scheduled payments that pay down the financed amount over the term, with the objective of owning the equipment at the end without a separate meaningful residual amount to address.

An EFA can make sense when:

The business expects to keep the equipment for most or all of its useful life
The equipment is central to ongoing operations
The owner wants a straightforward payment schedule
A clean end to the financing obligation is important

An EFA does not mean the business should ignore cash flow. The payment still needs to fit the equipment's expected contribution and the company's broader operating obligations.

$1 or $101 residual equipment lease

A $1 or $101 residual equipment lease is also generally designed as a near-full-payout arrangement.

The scheduled payments amortize essentially the full equipment cost during the regular term. At the end, the business has a nominal purchase option, such as $1 or $101, depending on the agreement.

Economically, this structure is built around paying down the equipment during the term and retaining it long term. It may be appropriate when the business expects to own and continue using the asset rather than replace it at the end of the financing period.

The important point is not the difference between $1 and $101. The important point is that the structure leaves little of the equipment cost outside the regular payment schedule.

10 percent residual structure

A 10 percent residual structure leaves a defined amount, often calculated as approximately 10 percent of the original equipment cost, to be addressed at the end of the regular term.

Because that amount is not recovered through the regular scheduled payments, the business is paying down less of the equipment cost during the term. That can reduce the scheduled payment compared with a near-full-payout structure.

The trade-off is straightforward. The business receives payment relief during the term, but it does not fully pay down the equipment during those scheduled payments. It needs a plan for the defined end-of-term amount, whether that means purchasing the equipment at the predetermined amount or using another option permitted by the agreement.

A 10 percent residual may be useful when:

Managing cash flow during the term is a meaningful priority
The owner wants a defined end-of-term amount
The business is comfortable planning for the remaining obligation

A lower scheduled payment does not mean the equipment costs less in total. It means the payment structure allocates more of the equipment cost to the end of the term.

FMV residual structure

An FMV residual structure bases the end-of-term purchase amount on the equipment's fair market value at that time rather than a fixed amount established at the beginning.

This type of structure may make sense when the business expects equipment replacement, technological obsolescence or a different end-of-term strategy. The business may want the flexibility to evaluate whether to retain, replace or otherwise address the equipment when the regular term ends.

Because the structure assumes value remains in the equipment at the end, less of the original cost may be paid down through the regular scheduled payments. That can support a lower scheduled payment than a near-full-payout arrangement.

The trade-off is uncertainty. The future fair market value is not known in advance. If the business wants to keep the equipment, the purchase amount at the end may be higher or lower than the owner would have expected.

Choosing the structure means deciding what problem you are solving

Choosing between a near-full-payout structure, such as an EFA or a $1 or $101 residual equipment lease, and a residual structure such as a 10 percent residual or FMV residual is really a question about three things:

How much of the equipment cost the business wants to pay down during the term
How much payment relief it wants during the term
What it wants to happen at the end

The objective is not to sell one structure over another. It is to determine what the business needs the financing to accomplish. An EFA or a $1 or $101 structure may be appropriate when paying down substantially all of the obligation during the term is the objective. A 10% residual can provide payment relief during the term while still allowing the customer to plan around a defined end amount. An FMV structure can provide a different type of flexibility where replacement or future equipment value matters.

A business that intends to keep the equipment for its full useful life and wants a clean end to the obligation may tend toward a near-full-payout structure.

A 10% residual and an FMV residual are both residual structures, but they tend to serve different purposes. A business may choose a 10% residual while fully expecting to keep the equipment, simply to reduce the scheduled payment during the term while accepting a known end-of-term amount. FMV structures are different. There, replacement cycles, technological obsolescence and end-of-term flexibility are usually the more relevant considerations.

Neither is inherently better. The business has to decide what it is solving for.

Illustrative example: how a 10 percent residual changes the structure

Illustrative example only. This is not a quote, payment calculation or financing offer.

Assume a business is considering a $250,000 equipment acquisition.

A 10% residual would represent approximately $25,000 to be addressed at the end of the regular term. Compared with a near-full-payout structure, leaving that defined residual can reduce the amount that must be recovered through the scheduled payments during the term and may therefore reduce the scheduled payment. Actual payments and transaction economics depend on the complete financing structure.

This illustration does not calculate an actual payment, assume an interest rate or compare total transaction cost. Its purpose is to show how the structure changes the amount paid down through the regular scheduled payments.

Financing structure and tax or accounting treatment are separate questions

The financing structure and the business's tax or accounting treatment are related considerations, but they are not the same question.

A business should not assume that an EFA, a $1 or $101 purchase option, a 10 percent residual or an FMV residual will receive a particular tax or accounting treatment. Those determinations depend on the specific transaction and the applicable tax and accounting rules.

Simplified Capital does not classify a customer's transaction as a capital lease, operating lease, finance lease or tax lease. The business's CPA or qualified tax adviser should determine how the transaction should be treated for the company's particular circumstances.

Section 179 and 100% bonus depreciation are different provisions

Section 179 and 100% bonus depreciation are separate federal provisions. Section 179 is an election that allows a business to deduct the cost of qualifying property in the year the property is placed in service, subject to dollar limits and taxable income limits. Additional first-year depreciation, often called bonus depreciation, is a separate provision under Internal Revenue Code section 168(k). For certain qualifying property, current federal law provides for 100% additional first-year depreciation when the applicable requirements are met.

A 10% residual does not by itself qualify or disqualify a transaction for either provision. The actual agreement, the ownership treatment for federal income tax purposes, and the applicable tax rules all matter. A business owner should not assume that a 10% residual prevents 100% bonus depreciation. The residual percentage alone does not answer that question.

That is why qualification of the taxpayer, the equipment and the transaction should be determined with the customer's CPA or qualified tax adviser. Simplified Capital does not determine tax treatment. We explain financing structures and alternatives and help evaluate the financing decision.

The financing discussion can focus on practical questions such as:

How much cash should remain available after the acquisition?
What payment obligation fits the business's expected cash flow?
How long does the owner expect to keep the equipment?
Is the equipment likely to become obsolete before the business would naturally replace it?
Does the business want a defined end amount or more end-of-term flexibility?
What delivery, installation and operational timeline should be coordinated with the equipment supplier?

For information about the broader October planning process, see Thinking About Equipment Before Year-End? October Is the Time to Start Planning.

Why October is a useful time to compare structures

If a business already expects to acquire equipment before year-end or early next year, October is a practical time to consider not only what equipment to buy, but how the acquisition should be structured.

Waiting until the last minute can compress the time available to:

Compare a near-full-payout structure with a residual structure
Understand the end-of-term obligation
Coordinate the financing with the equipment supplier
Review the expected delivery and installation timeline
Discuss tax and accounting questions with the CPA
Confirm that the payment structure fits the company's operating plan

The objective is not to create unnecessary urgency or make a purchase simply because the calendar is moving toward year-end. The objective is to give the business enough time to make a deliberate equipment and financing decision.

A sound equipment investment should make business sense independently. Financing is a tool for structuring that investment around the company's cash flow and ownership objectives.

Start with the business decision

The conversation does not have to begin with an application. It can begin with what you are buying, how long you expect to keep it and what you want the financing structure to accomplish.

Simplified Capital can help you evaluate possible commercial financing options and structure the conversation around the equipment and the business need. Your CPA or qualified tax adviser can address the tax and accounting treatment.

Simplified Capital has been serving business owners since 2002.

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To discuss an equipment financing situation, contact Simplified Capital at (866) 810-1305, info@simplifiedcapital.com or www.simplifiedcapital.com.

Sources

Tax, Legal and Accounting Disclaimer: Simplified Capital does not provide tax, legal or accounting advice, and does not determine how a transaction should be classified or whether it qualifies for Section 179, bonus depreciation or any other tax treatment. Customers should consult their CPA or qualified tax adviser regarding the treatment of any proposed transaction and their particular circumstances.