When it comes to leasing vehicles, there are two main options to consider: open-end leases and closed-end leases. These leasing structures have distinct characteristics and implications, especially at the end of the lease term.
Understanding the differences between open-end and closed-end leases is crucial in making an informed decision that aligns with your needs and financial goals.
In this comprehensive comparison, we will explore the key features, benefits, and considerations associated with each type of lease, allowing you to determine the most suitable option for your vehicle leasing requirements.
Open-end leases provide lessees with greater flexibility and the opportunity to assume the depreciation risk of the vehicle. Unlike closed-end leases, open-end leases do not have mileage limitations, making them particularly appealing for businesses with high mileage needs or those operating in diverse terrains. With an open-end lease, you have the freedom to use the vehicle for as long as you need, even beyond the initial term, with a month-to-month structure. However, it’s crucial to understand that assuming the depreciation risk means you are responsible for any shortfall between the vehicle’s actual market value and the predetermined residual value.
Flexibility is a significant advantage of open-end leases. Unlike closed-end leases, where you must return the vehicle at the end of the term, open-end leases allow you to keep the vehicle for as long as it meets your business needs. This flexibility enables you to adapt to changing circumstances, such as shifts in territories or scaling back operations, without incurring mileage penalties or the hassle of rearranging vehicles.
Open-end leases are particularly well-suited for heavy usage fleets that require flexibility and operate in off-road environments. If your business utilizes light and medium-duty trucks, utility vans, or specialized equipment, an open-end lease allows you to avoid costly fees associated with wear and tear and mileage overages.
While open-end leases offer flexibility, they also require lessees to assume the risks associated with depreciation. At the end of the lease, you may be responsible for any deficiency if the vehicle’s market value is lower than the predetermined residual value. It’s essential to carefully monitor the vehicle’s condition and market trends to anticipate potential shortfall. Conducting regular assessments and staying up-to-date with the market value of similar vehicles will help you make informed decisions and minimize financial surprises.
Additionally, open-end leases may involve a Terminal Rental Adjustment Clause (TRAC), which allows for adjustments against the outstanding book value of the vehicle at the end of the lease. This adjustment can result in a credit or a bill, depending on the vehicle’s actual value compared to the residual value. Awareness of the TRAC provisions and the potential financial implications is essential for effective cash flow management.
Closed-end leases, often called “walkaway” leases, are the more common option for consumers and businesses. In a closed-end lease, the lessor assumes the depreciation risk, providing lessees with a predictable and straightforward leasing experience. Closed-end leases have fixed terms, including a predetermined length and mileage allowance, and relieve lessees from any responsibility for the vehicle’s residual value. At the end of the lease, lessees have the option to return the vehicle, purchase it at the predetermined residual value, or explore lease extension opportunities.
One of the primary advantages of closed-end leases is predictability. With fixed terms and mileage allowances, you can budget your monthly payments accurately and plan for the future. Closed-end leases are ideal for businesses that prefer to avoid the uncertainties associated with depreciation and market fluctuations. By transferring the depreciation risk to the lessor, you can focus on your core operations without worrying about potential financial shortfalls.
Closed-end leases are particularly well-suited for fleets with consistent and predictable mileage patterns. If your fleet requires low, predictable mileage, a closed-end lease can be a cost-effective option. This is often the case for executive vehicles, which tend to have lower mileage and predictable usage patterns.
While closed-end leases provide predictability, it’s vital to adhere to the agreed-upon terms and conditions to avoid any excess mileage or wear and tear charges. Exceeding the predetermined mileage allowance or failing to maintain the vehicle in a safe operating condition may result in additional fees at the end of the lease. It is crucial to carefully monitor your fleet’s mileage and ensure regular maintenance to mitigate potential penalties.
At the end of a closed-end lease, you have the option to return the vehicle and walk away without any residual liabilities. However, if you choose to purchase the vehicle, you may have the opportunity to benefit from positive equity if the vehicle’s market value exceeds the predetermined residual value. Exploring resale opportunities or negotiating a reduced purchase price with the lessor can maximize the financial advantages of a closed-end lease.
When deciding between an open-end lease and a closed-end lease, it’s crucial to consider your specific needs and circumstances. Here are some factors to consider:
If you prefer to avoid financial uncertainty and potential additional payments at the end of the lease, a closed-end lease might be a better fit. With a closed-end lease, the lessor assumes the risk of depreciation, providing you with more predictability and peace of mind.
On the other hand, if you are willing to take on the risk and can handle potential additional payments, an open-end lease can offer more flexibility and potentially lower monthly payments.
Consider your anticipated mileage needs. If you expect to drive many kilometers per year, an open-end lease without mileage restrictions might be more suitable. However, if you have a good estimate of your annual mileage and don’t plan on exceeding the limits, a closed-end lease with predefined mileage restrictions can still be a viable option.
Evaluate the nature of your vehicle usage and the potential for wear and tear. If you anticipate heavy usage, off-road driving, or usage in industries with greater risk of damage, an open-end lease may better accommodate your needs. Open-end leases typically have more lenient wear and tear guidelines, allowing you to use the vehicle without worrying about excessive damage charges.
On the other hand, if you expect normal wear and tear or plan to use the vehicle primarily for commuting or light-duty tasks, a closed-end lease might be more suitable. Closed-end leases typically have stricter wear and tear guidelines, ensuring the vehicle is returned in good condition.
Consider the potential resale value of the vehicle. If you believe the vehicle will retain its value well, an open-end lease can provide an opportunity for profit if the market value exceeds the GRV. However, if the vehicle is likely to depreciate more than anticipated, an open-end lease could result in additional payments at the end of the lease.
A closed-end lease can offer peace of mind, as the lessor assumes the responsibility for the vehicle’s depreciation. If you prefer not to worry about the vehicle’s future market value and potential fluctuations, a closed-end lease might be a better choice.
Under an open-end lease, you are responsible for the vehicle’s book value. This is where the Terminal Rental Adjustment Clause (TRAC) comes into play. A TRAC arrangement features a final rental adjustment on the lease, which occurs after the vehicle is removed from service and sold. It allows you to manage your cash flow effectively.
With an open-end lease and a TRAC, you can adjust the rental payment against the vehicle’s outstanding book value at the end of the lease. When you return the vehicle, you will receive a credit or a bill for the difference between what you owe and the vehicle’s actual selling price.
Let’s take a look at a couple of examples to understand better how TRAC adjustments work:
In 2018, the Financial Accounting Standards Board (FASB) introduced new lease accounting rules known as ASC 842. These rules represent the most significant change in lease accounting in over 40 years. Under ASC 842, leases with durations of 12 months or less can remain off balance sheets. Leases exceeding 12 months must be classified under the lease criteria rules, with both operating and capital leases reported on the balance sheet.
Businesses must work closely with their accounting teams to ensure compliance with the new lease accounting rules. Although private companies and nonprofits have been granted a deadline extension to December 2021 due to the COVID-19 pandemic, being prepared for implementation is still essential.
Open-end and closed-end leases offer distinct advantages and considerations. Open-end leases provide flexibility and the opportunity to assume depreciation risks, making them suitable for businesses with high mileage or changing needs. However, they require careful monitoring of market values and potential shortfalls.
Closed-end leases offer predictability and simplicity, transferring depreciation risks to the lessor making them ideal for fleets with consistent mileage patterns. Understanding the differences and assessing your requirements will empower you to make an informed decision and select the lease option that optimally supports your fleet operations and financial objectives.
