When examining finance options for large purchases, such as jewelry financing, HVAC financing, or furniture financing, you may find many options available. However, these options typically boil down to either a loan or a lease. But what are the differences in the natures and the ramifications of leases and loans? Here are five ways loans and leases differ.
Loans Are Repaid with Interest
When a loan is issued, the loan principal is repaid with interest. For example, when $1,000 is borrowed, the interest payments may total $100 over the course of a year. Depending on the lender, these interest payments may be substantial. For example, the average interest rate for credit cards is 19.24% if the borrower has good credit and 22.57% if the borrower has only fair credit. This goes a long way to explaining why Americans have over $1 trillion in credit card debt. This also explains why loans are often prohibitive for bad credit financing.
Another difficulty with this option is that loans often have variable interest rates. This means that the total amount to be paid is unknown at the time of the purchase and may, in fact, skyrocket over the course of the loan.
Leases, however, state the lease payments in lease agreement. This amount is fixed, barring any unforeseen events, such as missed payments.
Loans Require Credit Approval
Since loans are a form of credit, they typically require a credit check before they are approved. Bad credit financing is often not available since loan officers often require “fair,” “good,” or “excellent” credit.
Moreover, because a credit check is required, loans typically take longer to approve than leases. And because loans rely so heavily on credit checks, banks and other lenders typically err on the side of caution if any questions about the borrower’s credit arise.
Leases, particularly lease-purchase programs, typically do not require credit approval before they are granted. For this reason alone, lease-purchase programs are viewed as a viable form of bad credit financing.
Loans Sometimes Require Collateral
Although not always true, loans often require collateral. Collateral is a guarantee, in the form of property, that the loan will be repaid. For example, when a bank issues a mortgage, the bank retains the deed as collateral.
Leases, do not require collateral. Rather, the nature of the lease is that the lessee merely rents the property from the lessor. At the end of the lease, lease payments are credited toward the purchase of the property, allowing the lessee to buy the property.
The Types of Loans Are Limited
Again, while it is not always true, most lenders limit the types of loans they will issue to the types of collateral that can be readily sold. For example, banks will often offer car loans, mortgages, and home equity loans. However, most banks do not offer loans for replacing a water heater, air conditioner, or refrigerator. Aside from being difficult to resell the collateral, loans on such purchases would require expenditures in time and effort to set up and service the loan than they would make back from the loan payments.
Leases, particularly lease-purchase programs, are available for a wide range of purchases and a wide range of amounts. For example, lease-purchase programs may be available for anything ranging from jewelry to eyeglasses.
Loans Sometimes Penalize Prepayment
Loans are typically structured over a particular term, with substantial penalties for prepayment. The reason for prepayment penalties relates to interest. Because interest payments are spread over the entire term of the loan, prepayment deprives the lender of interest payments that would otherwise be paid. Thus, prepayment penalties are meant to make up for lost interest payments.
Leases typically do not include prepayment penalties. This is because the lease payments are determined ahead of time, including prepayment options. Since the prepayment options are spelled out in the initial contract, the lessor is not deprived of the value of the lease in the event of prepayment. To the contrary, prepayment is built into the value of the lease.
Loans are often distinguished from leases in that loans require interest payments, collateral, and prepayment penalties. Moreover, because the types of loans are limited and credit checks are required, loans are usually not available for bad credit financing of small purchases like furniture, electronics, and jewelry.