Equipment Financing that drives your business forward.
If you’re a small business owner you understand how important it is to quickly and economically obtain, upgrade or replace the equipment needed to perform your daily tasks. Purchasing equipment outright can put substantial strain on your cash flow. Equipment financing may be the ideal solution to keep your business functioning at optimal performance or to expand to meet increasing demand. The following will provide an overview of how equipment financing works.
Equipment financing refers to a loan used to purchase business-related equipment, such as a restaurant oven, a vehicle or a copier scanner. Equipment loans provide for periodic payments that include interest and principal over a fixed term. As security for the loan, the lender may require a lien on the equipment as collateral against your debt. Once the loan is paid in full, you own the equipment free of any lien. The structure of an equipment loan may also impose a lien upon additional business assets or require a personal guarantee. Failure to pay your loan may result in the repossession of your business assets or your personal assets—in the case of a personal guarantee. A careful review of the loan terms is vital to understanding your risk.
If you are opening up a restaurant you will need a significant amount of equipment, including a commercial range, ovens, and a refrigerator. Let’s say the equipment costs total $75,000. You apply and are approved for an equipment loan equal to 80% of the equipment’s cost, or $61,500. That means your out-of-pocket expenses will be $13,500, and you can retain $61,500 in your cash reserves to offset all the other costs associated with a new business including the cost of the space, marketing and advertising, and permits and licenses.
Equipment financing is distinct from equipment leasing, wherein you pay the owner of the equipment periodic rent for use of the equipment over an agreed-upon period of time. At the end of the leasing term, unless you agree with the owner on renewal terms or a buyout, the equipment is returned to the owner. Generally, the qualifications for leasing are less stringent than for financing; however, if the equipment is necessary to your business, the endless payments on leased equipment without the prospect of future outright ownership may prove a more costly option.
As with all financing, rates and terms will vary depending on an applicant’s qualifications and current market conditions. Below are some sample rates and terms you can expect when shopping for an equipment loan.
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. 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 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 numerous variations. Here are a few common types you’ll come across:
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.
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.
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.
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 the type of lease you select will determine what you can write off and how.
Is a loan or lease better for your situation? Here are some questions you can ask yourself to find out.
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.
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.
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.
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.
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