What Is Equipment Financing?
Obtaining equipment is one of the most common reasons small business owners seek outside financing. You can acquire everything from computers and desks for an office to farm equipment and heavy machinery without shelling out the full price upfront.
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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What Is 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 as a restaurant oven or a company car. There is an enormous number of variations on equipment financing that cater to specific types of businesses and equipment.
The most important thing to understand about equipment financing, broadly speaking, is that it’s for financing a physical asset. Why does this matter? Unlike with, say, a working capital loan, the asset you’re purchasing serves as a kind of collateral. If you default on your loan or lease, the lender can repossess the asset. Because of this, equipment financing tends to be a more cost-effective and lower-risk way to acquire equipment than other forms of financing.
Who Qualifies For Equipment Financing?
Any business that utilizes physical equipment can probably make use of equipment financing. That includes such things as vehicles, computers, and machinery utilized by your business.
Qualifying for equipment financing is another matter. Equipment loans tend to be a relatively conservative type of financial product. In most cases, you’ll need to have good credit (600+), and you should be able to demonstrate the ability to service your equipment loan or lease.
You’ll also need to select the right equipment financer; that is to say, you’ll need to pick one that finances your type of equipment.
Why Use Equipment Financing?
Business owners commonly get equipment financing in these situations:
- You need expensive equipment but can’t afford to (or don’t want to) purchase that equipment upfront
- You need to replace your equipment frequently because it has a short lifespan, or you always need the latest in technology
- 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. However, 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 a loan taken out with the express purpose of purchasing equipment. Typically, the equipment secures the loan — if you can no longer afford to pay the loan, the equipment gets collected as collateral.
These loans are useful 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 that 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 will cost 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.
The cost of borrowing changes depending upon the amount borrowed, interest rate, and term length. For this reason, it’s essential to do the math before accepting an equipment loan. Equipment loan interest rates can vary wildly depending on your lender (8% – 30% is an extremely rough range for what you can expect), your credit rating, the amount of time you’ve been in business, and any number of other arcane formulas a specific lender decides to apply to your case. In most cases, equipment loan interest rates are fixed rather than variable.
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. It’s also more likely to cover additional soft costs associated with shipping and installing the equipment.
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 periodically need to switch out their equipment for an updated version.
If you want to own the equipment, some lessors 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 two major types of leases: capital and operating. The former functions a bit like a loan alternative and is used to finance the equipment you want to own long term. The latter is closer to a rental agreement and, in most cases, you’ll return the equipment to the lessor at the end of the lease. Both types have a large number of variations. Here are a few common types you’ll come across:
- Fair Market Value (FMV) Lease: With an FMV lease, you make regular payments while borrowing 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.
- $1 Buyout Lease: A type of capital lease where you’ll pay off the cost of the equipment, plus interest, over the course of the lease. In the end, you’ll owe exactly $1. Once you pay this residual, which is little more than a formality, you’ll fully own the equipment. 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 costs. 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 in practice, though their (usually fixed) interest rates fall within a similar range to equipment loans. 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. How leases affect your taxes is too complicated to cover within the scope of this article, but needless to say the type of lease you select will determine what you can write off and how.
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, 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 worth considering. Be aware that if you are planning on purchasing the equipment at the end of the term, you’ll likely have to pay all or some of the cost of the equipment. This arrangement will probably 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 funds or a loan — is a better option. While both loans and leases offer the opportunity 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.
How To Find Equipment Financers
In many cases, the same lenders you’d go to to look for any other kind of financing also offer some form of equipment financing. Most traditional banks and some credit unions can offer equipment loans and even, in some cases, leases.
With online lenders, it gets a little trickier. Many do not offer equipment financing, or if they do, it’s not a true equipment loan or lease; it’s just a loan you can use to buy equipment. On the other hand, some online lenders deal exclusively in equipment financing. Either way, make sure you know what kind of loan or lease you’re signing up for. Many third-party equipment financers also sell used equipment that’s been returned to them by previous lessees.
A final option is to deal with a captive lessor. These are equipment dealers who offer in-house financing on the equipment you’re acquiring.
We can help you get started with some handy comparisons of the top equipment financers available.
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.