What Is Equipment Financing & How Does It Work?
Whether you’re running a restaurant, a construction company, or even working out of your home, chances are your business needs equipment to perform its basic functions. If you can’t pay for equipment out of pocket, your best option may be to seek equipment financing.
While equipment financing might sound pretty straightforward on the surface, exploring this seemingly niche area of financing can be a bit like falling down a rabbit hole. By the end of this article, however, we hope to have you caught up on the basics.
Table of Contents
- What Is Equipment Financing?
- How Does Equipment Financing Work?
- Equipment Loaning VS Leasing
- Loan Or Lease? Five Considerations
- When Equipment Financing Is Right For Your Business
- How To Find Equipment Financers
- Final Thoughts
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.
How Does Equipment Financing Work?
When you’re seeking equipment financing, you’ll generally want an idea of what you’re buying before you even contact your equipment financer. You’ll also want an idea of who you’re planning to buy it from. That’s because, in most cases, your equipment financer is covering either all or a percentage of the cost of your equipment. In fact, many equipment financers will directly pay the vendor for the equipment without the money ever entering your bank account.
The exact terms of your financing will differ depending on whether you’re getting a loan or lease (more on this below), but most equipment financing terms last somewhere between two and seven years. Over that time, you’ll typically make monthly payments to your equipment financer to pay off the principal plus interest. Should you default on your loan or lease, your equipment financer will typically repossess your equipment to resell it.
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 upfront. 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: finance 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? Five 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 may have relatively few options for an equipment loan. That said, some non-traditional lenders do offer equipment loans that cover 100% of the costs. Still, you may have an easier time finding a lease that covers all of your expenses, especially if you also need help with transportation and installation costs.
How Much Can I Pay Each Month?
Fair market value 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 Do You Want To Account For The Equipment?
The type of financial agreement you’ve made can impact how the equipment is accounted for on your balance sheet. This applies mainly to leases, and operating leases in particular. Depending on your arrangement, the equipment may be considered an asset or an operating expense.
When Equipment Financing Is Right For Your Business
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 and leases 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.
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
If your business is in a situation similar to any of the ones above, the answer might be yes.
How To Find Equipment Financers
A great place to start looking for equipment financers is within our list of The Best Equipment Financing Companies For Small Businesses In 2021.
There’s also a good chance your bank does at least some equipment financing and, as is usually the case, banks generally have the best rates albeit with the most stringent qualifications.
With most 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 vendors who offer in-house financing on the equipment you’re acquiring.
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.