February 15, 2022 / 4 minute read
The consideration of open-end vs closed-end lease is an important one for fleet managers. While neither option is inherently better than the other, you need to choose the best fit for your company.
The key takeaway is that there are significant differences between the flexibility and risk in both leasing structures. This article can help you better understand these two leasing options and which is right for your organization.
Let's start by defining the two types of leases.
What is a closed-end lease?
Also known as a “walk away” or “fixed price” lease, a closed-end lease is the best option for organizations looking for minimum risk.
The lessor is responsible for any potential gain or loss at the end of the fixed term and the lease agreement limits the allowable mileage and protects the vehicle from excessive wear and tear.
What is an open-end lease?
An open-end lease combines the flexibility of ownership with the potential cash flow and tax advantages of leasing. It may also be referred to as a “capital lease”, “operating lease” or “TRAC lease.”
With this type of lease, your business can retain equity in the vehicle while freeing up capital. At the end of the term, you can decide whether to convert the vehicle to ownership, remarket the vehicle at a wholesale vehicle auction, or replace it.
An open-end lease can be risky, however, since the vehicle’s residual value depends on market conditions and the overall condition of the vehicle. The owner will identify the vehicle’s approximate depreciated book value when the lease agreement is made, but this value can fluctuate.
Two questions to ask when choosing fleet leases
As you evaluate the difference between an open end vs closed-end lease, keep these considerations in mind:
1. How risk-averse is your organization?
Is your business comfortable taking on risk? If it is, an open-end lease may be a better option.
In an open-end lease, your business assumes all the risk, but you also stand to benefit from all the financial gains at auction if a vehicle sells for more than the agreed-upon residual value.
However, should the actual vehicle usage end up being substantially more than the original estimate, your company will be responsible for any value loss.
For example, if your business signs an open-end lease, and expects the vehicle to do 120,000 km over four years, but it ends up doing 150,000 km over that time, you bear the risk from this additional usage when it comes to value depreciation.
You also need to be aware of other factors that can impact value, such as interest rates, seasonal fluctuations, and economic volatility. Traditionally auction value peaks in the spring and fall.
A closed-end lease shifts the risk to the vehicle management company. Assuming you return the vehicle in good condition, you can simply walk away at the end of the leasing term.
But with this option, you have less opportunity for gains when it comes time to sell.
2. How much flexibility does your business need?
With a closed-end lease, your business will have very little flexibility. A typical closed-end lease covers a 36-month period at 30,000 km per year for a total of 90,000 km over the life of the lease.
If after three years, the vehicle has gone over 90,000 km, then your business will pay a fee for the excess mileage. This fee is usually between 10 to 20 cents per excess kilometer, as specified in the leasing terms.
Conversely, if after three years, the vehicle has only covered 60,000 km, you’ll still need to return it. You will not receive any credit for the mileage difference.
Another flexibility consideration is the number of vehicles you’ll need to lease.
For example, let’s say your business has to let go of five fleet drivers one year into a closed-end lease term. You'll still need to pay for the remaining two years on the vehicles’ leases, even if the vehicles themselves are no longer being used. If your organization is smaller, and you know you’ll always be in the 50-unit range, closed-end leases are likely the best choice.
In contrast, an open-end lease provides greater flexibility, allowing organizations to expand or contract their fleet as needs evolve. For example, after a 12-month open-end lease period ends, you can continue paying on a month-to-month basis until the book value is zero and your organization owns the vehicle.
Choosing the best leasing structure really comes down to the needs of your organization. After you evaluate your risk tolerance and need for flexibility, you’ll have a clearer idea about which option to choose.
The result of the correct choice is a vehicle fleet that is efficient, profitable, and effective at allowing your service team to keep doing what they do best.
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