Understanding your options regarding balloon payments or about an Operating Lease vs Chattel Mortgage. We answer some of your questions here.
What is a Chattel Mortgage?
Simply put it is a mortgage on a movable item such as a commercial vehicle or machinery.
A chattel mortgage is where you take legal ownership of the chattel (movable item) and the lender secures the loan by putting a mortgage on the chattel.
The main benefit of having a chattel mortgage is as you will own the chattel you can claim depreciation and other benefits reserved only for businesses. Once the chattel mortgage is paid out in full the lender removes the mortgage.
This differs from a consumer loan where the lender owns the chattel until the loan is paid out.
Other benefits to taking out a chattel mortgage are lower interest rates, flexible loan terms, adding insurance and opting in for a residual value or balloon payment.
What is an operating lease?
An operating lease quite often is utilised when needing to obtain an asset on a short-term basis. The term is considered short compared to the useful life of the asset. With the technology world changing rapidly often equipment can be considered obsolete before the end of its workable life. It is considered a rental expense and is not capitalized. The lessor accounts the equipment as their asset and therefore claims the depreciation. The lessee accounts the rental expense in their off-balance sheet financing. The benefit of this for the lessee is the asset is not recorded on the lessee’s balance sheet as a liability and that can improve their financial ratios.
At the end of the operating lease, the title to the asset does not pass to the lessee but remains with the lessor.
Accordingly, at the end of an operating lease, the lessee has several possibilities:
What happens at the end of an operating lease? The asset is kept with the lessor, not with the lessee. Lessee’s have the following possibilities to explore at the end of the operating lease:
● The pursuit of the lease
● Return of the equipment
● Renewal of equipment
● Restoration of equipment
● Purchase of equipment at their market value
To recap the main benefits of an operating lease:
● As they are off balance sheet so are an operating expense deductible from profits
● Improvement of cash-flow
● The economy of corporate taxes
What is a residual or a balloon?
The residual value/ balloon payment can be part of a loan contract. Having a residual value or balloon payment allows you to have reduced payments throughout the loan term in exchange for a lump sum due at the end of the loan contract.
There are some great benefits to having a residual/balloon payment including that it can increase the affordability of the loan, it can assist with cash flow management which is very useful for seasonal businesses and you can also match the loan balance to the value of the assets over the life of the loan.
What is interest rates and how are they determined and influenced.
An interest rate from the borrower’s point of view is the cost of borrowing the money and from the lender’s point of view, it is the compensation for the lending risk and the service provided. There are many different types of loans and interest rates can vary depending on different factors. Both internal and outside factors can determine the interest rate offered to you.
Risk or default and inflation are determining factors in regards to interest rates offered by lenders. As a lender they may lend money today, assuming all payments are made over the loan term, by the time it is paid back the goods and services cost may have gone up, therefore your money’s original purchasing power has declined. The interest paid is to protect them against this inflation and to provide compensation for their services.
Inflation is another contributing factor to interest rates. Higher inflation usually results in higher interest rates and lower inflation usually results in lower inflation rates. Higher interest rates occur due to lenders demand to compensate as their money that will be paid back in the future will have a decreased purchasing power. A simple example to explain inflation is: Today a litre of milk is $2 but in 5 or 10 years time it may be $5. Another important factor in the determination of interest rates is the supply and demand of credit. Usually, an increase in demand yields an increase in interest rates and a decrease in demand yields a decrease in interest rates. In regards to supply of credit, where supply increases it usually decreases the interest rates and decreased supply usually increase interest rates.
What are some of the factors that influence the rates given on asset purchases?
If you are assessed as a low-risk borrower you will likely be charged a low-interest rate and if you are assessed as a high-risk borrower, the interest rate offered will be higher. Your risk profile is made up through many factors like but not limited to risk profile of asset, credit rating and collateral.
Other factors are also a big part of the rates offered. Such as supply & demand of credit for the domestic & international market, Government Monetary Policy and inflation.
My residual value/ balloon payment is due. What are my options?
So, you have reached the end of your loan term and your residual value/ balloon payment is due. There are three options for you to consider:
1. If you have enough cash reserves to pay it out in full without emptying the bank, then this is a very good option to consider.
2. You can consider refinancing your loan with your current loan provider.
3. Call Asset Finance Shop to discuss your refinancing options. As finance brokers, we have experience in sourcing the best asset finance for your business.
If you are in the position to consider all three options we urge that you do and may be worth getting advice from your accountant as well.
When is a deposit required for commercial asset finance?
Not if you have collateral such as property to borrow against. If you do not have any collateral your risk profile will be higher and a deposit may be required. Talk to us to find out.
What’s the most tax effective asset funding solution for me?
Great question and a common one. The answer isn’t a one size fits all box unfortunately. Things such as your business structure and set up can influence what would be more tax effective. Best to discuss your individual situation via a professional consultation with your accountant.