Equipment Financing: Lease VS Loan
Chances are, if you’re running a business, you’ll need equipment, whether it takes the form of chairs, registers, or pile drivers. Purchasing these items may require more cash than you have on hand, forcing you to take out a loan. On the other hand, purchasing equipment that becomes obsolete quickly often doesn’t make sense, fiscally. In these instances, you may want to look at equipment financing as a solution.
Below, we’ll take look at some of the pros and cons of buying your equipment with a loan versus leasing it.
Best For: Equipment with long-term utility; companies that can afford a down payment; companies that don’t need the equipment right away.
We’ll start with equipment loans since they’re much easier to understand. An equipment loan is (as its name implies) a loan that is used to purchase equipment. What distinguishes equipment loans from other loans is that the equipment itself serves as collateral. If you can’t make your payment, the lender simply repossesses the equipment. Be aware that some lenders will also file blanket liens against your business, so make sure you know what you’re putting on the table before you sign.
Most equipment loans don’t cover the entirety of an item’s cost, so you’ll probably need to cobble together a down payment. This will typically run between 10 – 20 percent of the total cost. Keep in mind that, as is the case with most long-term loans, getting equipment financing can be a time-consuming process.
Once the loan is paid off, the equipment is yours to continue to use, or to resell. For items that don’t depreciate quickly, this is a pretty good deal. If, however, we’re talking about computer hardware (assuming you’re working in an industry where you need to stay on the cutting edge) or similar technology that will be rendered nearly worthless in a matter of years, an equipment loan can be a bad investment. You’re effectively inflating the price of an item undergoing immediate depreciation.
And make no mistake, an equipment loan can be costly. In addition to the down payment, you’ll be paying back interest plus any origination fees charged by the lending entity.
Loans do offer additional advantages over leases, however. When a loan is paid off, the deal is unambiguously done. There are no questions about what happens to the equipment or about strange clauses in your agreement.
Best For: Equipment that needs to be replaced or upgraded frequently; companies that can’t afford a down payment; companies that need equipment quickly.
A lease is a contract that guarantees the lessee (you) the use of the lessor (the owner’s) equipment for an agreed-upon term in exchange for payment. The lease outlines terms of behavior for both parties. Lease agreements can be made in as little as a few hours, depending on the availability of the equipment and the amount of background checking involved.
Unlike loans, many equipment leases don’t require collateral or down payments, so there’s less of an upfront investment for you to make. Since the lessor still technically owns the item, they’re responsible for reasonable maintenance of it, assuming you’re using it in accordance with the lease.
But the primary virtue of leasing is that, at the end of the lease, you have the option to either buy or return the equipment. If you think the equipment is worth keeping long-term, you buy it outright. After that, you own it. If the equipment is looking obsolete, you can return it. Obviously, you’ll be without the item at that point and will need to sign another lease for a new piece of equipment. Some lessors will also give you the option to renew or extend your lease.
When it comes to buying equipment once your lease is up, there are a number of variations. The most common are:
- $1 Buyout Lease: These are very similar to loans in that the entire cost of the item will probably have been figured into your interest rate and term length. When your lease is up, you make a symbolic purchase by paying the lessor a dollar.
- 10 Percent Option Lease: Similar to the previous, except that less of the cost of the product is built into the lease, which usually translates to lower interest rates. You end up paying 10 (or some other) percent of the equipment’s cost.
- Fair Market Value (FMV) Lease: These leases usually pair comparatively low rates with a fair market value buyout clause. FMV is roughly equal to what an informed consumer would expect to pay for the equipment at the end of the lease. Since the lessor assumes a bit more risk here, your credit rating may factor more heavily.
Leases tend to be more expensive than loans in the long run, but you must calculate the advantages of owning and maintaining the product versus using and returning it.
Here’s an example of the terms you might see for both an equipment loan and an equipment lease on a $12,000 item, assuming you want to own the equipment eventually:
|Interest rate:||6%||Interest rate:||15%|
|Term length:||24 months||Term length:||24 months|
|Monthly payment:||$443.21||Monthly payment:||$581.84|
|Origination fee:||4%||Origination fee:||—|
|Down payment:||$2,000||Down payment:||—|
|Cost to purchase:||—||Cost to purchase:||$1,200 (10% Buyout)|
|Total cost of equipment:||$13,637||Total cost of equipment:||$15,164|
By spreading the cost of the equipment out over 2 years, you’re paying a premium either way. You’ll notice a few tradeoffs. In the case of the loan, you’re paying a lower interest rate on a smaller amount of money–$10,000 vs. $12,000–but you have to have coughed up $2,000 in advance.
While the lease looks like an inferior deal overall, there are a few caveats to consider. If you don’t want to eventually own the equipment, you can subtract $1,200 from the cost (though you won’t be left with an asset at the end of the term). And you won’t be responsible for repairs for the duration of the lease as you would be if you had taken out a loan on the equipment.
Deciding whether to sign a lease or take out a loan can be a bit of a gamble, but if you factor in the value (or lack thereof) of owning the equipment long-term, you’ll be able to make the best decision for your company.