How Equipment Financing Works and What You Should Know
March 7, 2022
Whether you realize it or not, there are very few small businesses out there that aren’t highly dependent on equipment.
Office buildings require computers, desks, chairs, keyboards and mice, printers, copy machines, televisions, projectors, even coffee makers. Restaurants need tables, chairs, POS systems, ovens, range tops, coolers, and freezers. How many businesses need a vehicle?
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No matter your business or industry, you’ll need equipment. And while there are as many different types of business loans out there as there are businesses, when it comes to purchasing a piece of equipment, an equipment loan is often the best answer.
So What is an Equipment Loan?
In a traditional loan, there’s a fairly straightforward process. You apply for the loan, the lender reviews your credit and qualifications, and then a decision is made. You make monthly payments based on the size of the loan, repayment term, and interest rate. Funds from a traditional loan can be used to fund hires, real estate purchases, inventory, and any other business needs.
Equipment loans are loans designed specifically and solely for buying business equipment. Think physical assets.
The big difference between equipment loans and other financial products is that the lender will hold the new equipment as collateral against the loan. That is, if your company defaults on the loan, the borrower will be able to repossess the equipment.
That ability to repossess physical assets protects the lender from too much financial risk. After all, since the loan size is determined based directly on the cost of the equipment, repossessing the equipment should theoretically make the lender nearly whole.
Upsides to Equipment Loans
Equipment loans are often very affordable. Because of the aforementioned fact that the lender can repossess the equipment purchased, many equipment loans feature very management interest rates and loan terms.
Less expensive up front than buying outright. Say you’re buying a pizza oven for your restaurant business. Maybe it costs $25,000. The typical equipment loan will require a 20% down payment ($5,000) followed by monthly payments. It’s a much better proposition for many small business owners to have to put up only $5,000 for such an oven. After all, a pizzeria can’t function without an oven.
Helps build credit, particularly when you’re a startup. Equipment loans are a great option for new businesses, when your company doesn’t have many assets. So not only does an equipment loan mean that your company is getting the tools it needs to operate, it’s also making your business credit stronger for later on, when your business needs new financing.
Downsides to Equipment Loans
Narrow focus. Business financing can sometimes lead to a large influx of cash with many purposes. In addition to buying equipment, you might also be able to pay employees, pay off other debt, or otherwise function as working capital. On the other hand, equipment loans are meant for equipment, full stop. If you’re looking to use outside funding to make a hire, you’ll need to look into other financing options.
You’ll sometimes overpay for equipment. Such is the nature of paying full price plus interest. Even at a very low interest rate, you’ll end up spending more than the price of the equipment if you buy using an equipment loan than you would if you saved up and bought the equipment outright. In many contexts, buying equipment outright simply isn’t feasible, but for smaller purchases, it’s worth considering the long-term financial picture.
Depreciation. What’s your plan for that equipment? If it’s a piece of equipment that will depreciate quickly or otherwise require replacement in the near future, those interest payments will become a significant issue, as reselling the equipment after the repayment time could result in a loss.
Should You Lease?
Another equipment option is leasing. Leasing is a strong option in several specific circumstances. Equipment leasing works like this: you do not provide a down payment, and there’s no actual purchase. Instead, you are effectively paying rent on a piece of equipment. After the end of the lease period, the equipment is returned to the owner, or purchased by the company that had done the leasing.
Leasing equipment can be a great option when obsolescence or depreciation is likely. If you know you’re going to need to replace very expensive equipment every three years, do you want to buy it outright? Or does it make more sense to make smaller payments in perpetuity, never outright owning the equipment.
Another situation in which leasing might make sense is for certain types of equipment that will only be necessary in the short term. If you’re just starting out, leasing a piece of equipment that will get your company off the ground could be a smart choice; you can purchase (or get an equipment loan) for the upgraded or long-term version once the lease has ended.
Finally, most leases either require a much smaller down payment or don’t require one at all. That up-front cost can be prohibitive for many small businesses.
How to Get an Equipment Loan
To get favorable terms on an equipment loan, do everything possible to show the lenders that your small business’s equipment purchases will lead directly to the lender making money.
That process means ensuring your business plan is updated, realistic, and accurate up to the current time for your company. It means making sure your business credit score is as high as possible, that your credit report is accurate, and that your credit history is as blemish-free as possible.
Preparing to get an equipment loan also means making sure your financial statements are on hand and in order. Remember that for some lenders, you’ll need to show your personal credit score or, in cases where the borrower has bad credit, make a personal guarantee to the lender.
Once you’re sure that your business is ready for the scrutiny that comes with a business loan approval process, you’ll need to look into the various financial institutions that offer equipment loans.
Traditional banks, like Chase Bank, offer equipment loans, of course. But there are also online lenders, like iCapital Funding, that are able to provide equipment loans as well. Which route you take depends on a variety of factors: your credit, your company’s annual revenue and industry, the loan amount, the period of time you’re looking for repayment… Make sure that you’re casting a wide net and finding a lending partner who’s able to best serve your company’s needs.
How to Choose the Right Financing
After all of that, are you sure that an equipment loan is the best option? If you’ve got bad credit, a limited business history, not much revenue, or a ton of different needs, you may want to do a bit more research.
There are any number of different types of financing available to entrepreneurs today.
Business lines of credit: a financial institution offers your company a credit maximum. You make purchases drawing on that money, under that maximum, and pay back only what you spend (plus interest, of course).
Traditional term loans: like you read above, a traditional term loan is one where a bank or online lender offers a lump sum which is paid back over time, with interest.
SBA Loans: The United States Small Business Administration (SBA) guarantees some loans. While this type of loan is often more difficult to qualify for, the taxpayer guarantee shields the lender from undue financial risk, meaning that terms are often very favorable for borrowers.
Merchant Cash Advances: not loans, merchant cash advances are a financial product where a company effectively purchases a percentage of future credit and debit card transactions. Be careful with these, as those credit card transaction fees can cause some serious cash flow issues. These cash advantages have massive upsides, but make sure you’re in the right situation.
Every company needs equipment to function.
At the bare minimum, most companies need space, computers, seating, and peripherals. Equipment loans are a great option for making sure that your company has the things it needs to prosper, whether that equipment is rowing machines, construction equipment, or a griddle.