Break Fees and Payout Calculations on Equipment Finance

When buying a new piece of equipment or machinery, the last thing you’re probably thinking about is selling it. While resale value into the future will often be a buying consideration it’s not usually a high priority at the time of purchase and when arranging cheap rate equipment finance. Alert – it should be!

Business owners can save on finance fees and charges by considering upfront, at what time in the life of the equipment or more specifically in the term of the finance contract that they may upgrade that equipment by sale or trade-in as the decision.

Equipment finance contracts are typically set up over a fixed finance term. That, along with the fixed interest rate, results in a fixed repayment which assists the business with forwarding cash flow planning and certainty. But in the event that the finance contract is concluded prior to the fixed term as agreed, the payout figure includes penalties or break fees.

A fixed-term finance contract can be concluded prior to the agreed term when:

  • The equipment is traded in or sold during the finance term. This would require the business owner to finalise the existing finance contract.
  • If the equipment finance is refinanced for a range of reasons. Refinancing involves establishing a new finance contract and concluding the original loan early.

When these scenarios arise, the equipment owner would need to contact their lender for a payout figure and that is where fees and charges apply.

Equipment Finance Payout Calculations

Equipment finance is commercial finance and as opposed to highly regulated consumer loans, this sector is not as regulated. How a payout is calculated when a loan is concluded early and what break fees may apply is at the discretion of individual lenders.

In calculating payouts on equipment finance, there are 3 methods that are commonly utilised:

  • The discount rate method
  • Interest payable charged at a percentage of the original rate
  • 7/8ths or using the Rule of 78s

When setting up a finance contract, the details of which method is implemented and what actual fees and charges apply should be included in the contract. Each of these three methods will deliver a different outcome for the payout.

Discount Rate Formulation

To calculate the early payout on equipment finance with the discount rate method involves firstly calculating the Present Value (PV) of the loan. This value is not the valuation of the equipment at that time but of the monies outstanding on the loan – principal and interest.

The PV of both any balloon or residual and the repayments which are outstanding is calculated using a discounted rate of interest. The discount rate is determined by individual lenders and will be set out in the finance contract. This rate is applied to outstanding amounts according to the number of repayment months that are still due.

With the PV calculated, the payout is then tallied which includes:

  • Any repayment arrears which are owed.
  • The total of repayments still due to be paid for the rest of the finance term at the PV.
  • The PV of the balloon or residual.
  • Fees and charges as applicable by that lender.

Interest Percentage Method

With this payout calculation method, the total of outstanding amounts – repayments and balloon, are included and interest calculated on these amounts at an interest rate which is a percentage of the interest rate initially applied to the loan. Additional early payout fees may also apply.

Rule of 78s

The Rule of 78s aka 7/8ths or Rule of 78 has been covered in our articles in great detail. We recommend you refer to the original article for full details as we will include a brief summary here. The ATO has a ruling which determines when this payout calculation can be utilised.

In simple terms, this rule relates to at what point of time over the term of a finance contract that the interest payable is actually charged to the loan account. When a greater amount of the total loan interest is charged in the early part of the loan term, less of the principal is being repaid. So when it comes time for the payout, a greater amount of the original loan, the principal, may still be owed than the borrower may have thought. The principal is not reduced as quickly.

The early repayments are used to pay down interest, not the principal. Referring to statements issued by your lender should reveal how much of the interest and the principal is being paid off each month.

Minimising the Equipment Loan Payout Figure

When discussing a finance contract with a lender such as Jade Equipment Finance, borrowers can do themselves a favour by considering how long they intend to keep the equipment in service. While it is appealing to opt for a longer finance term such as the maximum of 7 years in order to get as low repayments as possible, it may not be saved.

If you intend to upgrade in 4-5 years then opting for a 4-5 finance term may be smarter. By selling or trading when the finance term is finalised, no break fees would be charged. Yes, the repayments would be greater than for a 6-7 year term but you could save at the end. To see how loan terms and repayments interact, refer to our equipment finance calculator.

Your Jade consultant will work through the options when sourcing your equipment finance to ensure it meets your specific requirements.

Contact 1300 000 003 for quotes on cheap lending.

DISCLAIMER: IF MISINTERPRETATIONS, MISREPRESENTATION OR ERRORS EXIST IN THIS ARTICLE, NO LIABILITY IS ACCEPTED. THE INFORMATION IS PROVIDED ONLY FOR GENERAL PURPOSES AND NOT IN ANY MANNER INTENDED AS THE ONLY SOURCE FOR MAKING FINANCIAL DECISIONS. THOSE THAT CONSIDER THEY REQUIRE ADDITIONAL GUIDANCE OR ADVICE SHOULD REFER TO AN INDEPENDENT FINANCIAL ADVISOR.