What Is Equipment Financing?
Equipment financing is a way for businesses to acquire hardware, vehicles, software, and other hard assets with third-party funds. Though equipment financing has a lot in common with traditional term loans, it has its own distinguishing properties, notably the option to lease rather than buy equipment outright. Additionally, the ability to secure your debt with the equipment you’re purchasing can result in lower rates than you’d get with an unsecured working capital loan.
There are many ways to finance equipment, whether you want to own or rent. The right option for you will depend on the type of equipment you’re seeking, your accounting practices, and how quickly the asset depreciates.
Types Of Equipment Financing
Below are descriptions of some of the most common types of equipment financing you’re likely to come across. Consider which ones might be best for your needs.
Equipment loans are similar to more traditional medium-to-long term loans. As mentioned above, these loans are usually secured debt — the equipment purchased serves as the collateral. Typically, the lender will cover about 80 percent of the full cost of the equipment, so you’ll need to be prepared to cover the remaining 20 percent or so out of pocket.
Capital leases, while still technically leases, transfer ownership and liability for an asset to the lessee (the person getting the lease). If you want to own the equipment by the end of the lease, but don’t have money for a down payment on an equipment loan, you may want to consider a capital lease. Popular capital leases include $1 buyout leases and other arrangements that offer buyouts at less than fair market value.
Operating leases, sometimes called “true” leases, are more like long-term rental agreements, but they come with the option to buy at the end of the lease. Operating leases are popular for equipment that depreciates or becomes obsolete quickly. The lessor (the financing company) typically retains ownership of the asset. Operating lease terms are usually short, and payments are considered operating experiences. Note that the accounting practices and laws associated with operating leases will be changing soon.
A tax lease is a lease in which the lessor is considered the owner of the asset for federal tax purposes. That means the lessor assumes both the costs and benefits of ownership, while the lessee can claim their monthly lease payments as a business expense on their taxes. Tax leases are technically operating leases, but not all operating leases are tax leases.
Terminal Rental Adjustment Clause (TRAC) leases allow for more flexibility in your residual and monthly payments. You’re most likely to encounter them if you’re looking to lease a commercial vehicle. TRAC leases are often also tax leases.
Synthetic leases are a highly-specialized form of tax lease in which a new business entity is created to own the equipment for the duration of the lease. That entity then leases the equipment to the lessee. A synthetic lease essentially counts as a capital lease for tax purposes and an operating lease for accounting ones. You’ll generally only encounter synthetic leases with large commercial banks.
Lines Of Credit
Banks and alternative lenders will sometimes offer equipment loans or leases in the form of lines of credit. These lines of credit can be tapped for one or more equipment loans or leases, up to the credit limit. Compared to regular lines of credit, equipment-focused lines of credit usually have a much shorter expiration date.
Are You Eligible For Equipment Financing?
Equipment lending and leasing guidelines are pretty similar to those of other types of financing. More often than not, standards are more relaxed for equipment leases than for equipment loans.
Lenders and lessors will look at the following factors to determine your eligibility:
- Time in business: The longer you’ve been in business, the less risky you’ll appear.
- Personal credit score: This will not only affect your eligibility, but the rates you’re offered.
- Business revenue: Does your business generate enough money to make timely payments? In the case of loans, in particular, this will affect the amount of money lenders are willing to offer.
- The specific equipment you’re financing: Lessors often have relationships with particular vendors that may affect what they’re willing to finance. Beyond that, the equipment you’re financing will serve as collateral for your loan or lease. As such the lender needs to assess and approve the asset.
Each lender or lessor will have different criteria for the factors above, as well as areas of specialty, so be prepared to spend time researching before you find one that meets your needs.
For more information about the equipment financing process, take a look at some our resources: