What is Equipment Financing?
Obtaining equipment is one of the most common reasons small business owners seek outside financing. Everything from computers and desks for an office to farm equipment and heavy machinery can be acquired without shelling out the full price up-front.
But how does equipment financing work? Should you finance the equipment for your business instead of buying it outright? If so, should you get an equipment loan or lease? Keep reading to find out!
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Why Use Equipment Financing?
Equipment financing is the use of a loan or lease to purchase or borrow hard assets for your business. This type of financing might be used to purchase or borrow any physical asset, such a restaurant oven or company car.
Businesses commonly get equipment financing in these situations:
- You need expensive equipment, but can’t afford to (or don’t want to) purchase that equipment up-front,
- You need to replace your equipment frequently because it has a short lifespan or you always need the latest in technology, or…
- You need some combination of the above.
Is equipment financing right for your business? If your business is in a situation similar to any of the ones above, the answer might be yes. But there are a couple of different ways you can get financing, and it’s important to know the difference.
Equipment Loaning vs. Leasing
There are two common ways to finance equipment: through a loan or a lease. While both achieve the same ends—giving you access to the equipment needed to run your business—there are plenty of differences between the two methods.
Here’s a rundown on each:
An equipment loan is, simply, a loan taken out with the express purpose of purchasing equipment. Normally, the loan is secured by the equipment—if you can no longer afford to pay the loan, the equipment will simply be collected as collateral.
These loans are very good for business owners that need a piece of equipment long-term, but can’t afford to make the purchase outright. A lending institution might agree to extend the majority of the capital so you can pay in periodic increments.
There are a few downsides to this arrangement. Most lending institutions will only agree to pay 80% – 90% of the cost, leaving you to cover the other 10% – 20%.
The other downside is that, in the long term, the arrangement will ultimately cost more than if you had just bought the equipment outright.
Here’s an example of what an equipment loan might look like for a $25K piece of equipment:
|20% down payment:||$5,000|
|Term length:||36 months|
|Total cost of borrowing:||$22,232|
|Total cost of equipment:||$27,232|
In the example above, using a loan costs almost $2.5K more than purchasing the equipment up-front. On the other hand, the monthly payments are much more manageable than a large one-time payment.
Obviously, the cost of borrowing changes depending upon the amount borrowed, interest rate, and term length. For this reason, it’s important to do the math before accepting an equipment loan.
Leasing equipment is a popular option if you need to trade out equipment frequently or don’t have the capital to pay the down payment required for a loan.
Instead of borrowing money to purchase the equipment, you’re paying a fee to borrow the equipment. The lessor (the leasing company) technically maintains ownership of the equipment, but lets you use it.
Lease arrangements can vary depending upon your company’s needs. Most commonly, merchants enter into a lease agreement if they need to periodically switch out their equipment for an updated version.
For those who do want to eventually own the equipment, some lessors do offer the option of purchasing the equipment at the end of the term.
Leasing generally carries lower monthly payments than a loan, but might wind up being more expensive in the long run. In part, leases tend to be more expensive because they carry a larger interest rate than a loan.
There are three major types of equipment leasing. Here are the basics of each one:
- Fair Market Value (FMV) Lease: With a FMV lease, you make regular payments to borrow the equipment for a set term. When the term is up, you have the option of returning the equipment, or purchasing it at its fair market value. These loans tend to have the lowest monthly payments, but are more difficult to qualify for.
- $1 Buyout Lease: Similar to the above, you make regular payments to borrow the equipment for a set term. At the end of the term, you have the option of purchasing the equipment for $1. Aside from technical differences, this type of lease is very similar to a loan in terms of structure and cost.
- 10% Option Lease: This lease is the same as a $1 lease, but at the end of the term you have the option of purchasing the equipment for 10% of its FMV. These tend to carry lower monthly payments than a $1 buyout lease.
Here’s an example of what a 10% option lease might look like for $25K worth of equipment:
|Value of equipment:||$25,000|
|Term length:||36 months|
|Total cost of leasing:||$28,079|
|Cost to purchase:||$2,500|
|Total cost of equipment:||$30,579|
A lease tends to be more expensive than a loan, but may offer benefits. Depending on the arrangement, you might be able to write off the entirety of the cost of the lease on your taxes, and leases do not show up on your records the same way as loans.
Loan or Lease? Four Considerations
Is a loan or lease better for your particular situation? Here are some questions you can ask yourself to find out.
Can I afford a 20% down payment?
If you can’t afford to pay 20% of the value of the equipment out of your own pocket, you might have difficulty finding a lender that is willing to work with you. In this case, a lease might be your only option.
How much can I pay each month?
Leases tend to carry smaller monthly payments than a loan. If you’re operating on a thin profit margin, a lease is definitely worth considering. Be aware that if you are planing on purchasing the equipment at the end of the term, chances are you’ll have to pay all or some of the cost of the equipment when the time comes, and that the arrangement will likely be more expensive in the long run.
How long do I need this equipment?
The general rule of thumb is that if you need the equipment for more than three years, purchasing—through your own funds or a loan—is a better option. While both loans and leases offer the option of owning the equipment at some point, loans tend to be less expensive.
How soon will this equipment wear out/become obsolete?
If you’re using equipment that will quickly wear out or become obsolete, leasing might be the cheaper option, and in the end you don’t have to decide what to do with the outdated equipment.
On the other hand, when shopping for a lease, you want to be sure that your equipment isn’t going to become obsolete before the lease terms are up. You’re still responsible for paying until the end of the term, even if you can no longer use the equipment.
In general, leasing is best for equipment that regularly needs upgrading, and a loan is best for equipment that will last a long time while retaining its usefulness.
Regardless of which way you choose to finance your equipment, do the math and read over the contract to ensure the terms work for your business.