“What Is A Lease Balloon Payment?”
A lease balloon payment is the amount of principal still remaining at the end of a lease term.
For example, all operating leases require that at least 10% of the initial purchase price of the asset be outstanding at the end of the lease term in order for the lease to qualify as an operating lease.
This 10% amount outstanding is effectively a balloon payment.
From a debt servicing point of view, your monthly lease payment is calculated based on the amount of principal retired and the amount of interest charge on the balance.
Because the entire balloon payment amount is outstanding during the full lease term, you are effectively paying interest on this full amount each and every month.
For the most part, the effective cost of capital or interest rate associated with a lease with a balloon payment is going to be less than a lease without one.
The balloon payment amount can also be higher than 10%. The reason for going this is to lower the cash flow requirements during the leasing term.
The amount of a balloon payment that is going to be possible in any given situation is going to vary according to the lease financing criteria of the leasing company, the asset being financed, and the credit and financial profile of the borrower or lessee.
Balloon payments that you have an option to repay at the end of a lease term are classified as an operating lease and typically are not going to be higher than 10% unless the asset has a very high probability of holding its value over time.
For larger balloon payments where the lessee has agreed to purchase the asset and make the payment at the end of the leasing term, the lease is a capital lease by definition.
The strategy for taking advantage of a balloon payment can result in both cash flow and taxation advantages to the lessee. In order to make sure that a certain lease structure can yield these specific benefits, you should always first consider reviewing the specifics of the lease agreement with your accountant and/or tax adviser.
Larger balloon payments are going to me more likely with shorter leasing terms as the risk to the lender or leasing company from non payment is going to be less due the shorter amount of asset use and depreciation. This is not going to be true in all cases, but will apply most of the time.
One of the keys to effectively managing this type of financing strategy is to allow for the repayment of the balloon payment in your cash flow so that when it comes time to make payment that the business does not get drained of all available cash, or incur additional debt that will be difficult to manage from that point forward.
If you would like to know more about equipment leasing balloon payments, please give us a call and we’ll make sure you get all your questions answered right away.