Article Summary: There are a couple of different ways to finance the equipment a small business needs. Equipment financing is basically approached by either leasing or financing an equipment purchase. And, while many people associate large construction equipment or the machines used in manufacturing as "equipment," the reality is just about any asset used to conduct business could be considered "equipment."
For example, the pizza oven used in a restaurant or the computers used by a software developer could both be either leased, or purchased, as equipment.
While there's no hard and fast rules for when to lease or when to purchase, it's important to understand the differences so you can make an informed decision regarding which is the best approach to meet your equipment financing needs. Continue reading to learn more about how leasing and financing work; and even some of the pros and cons associated with leasing or financing an equipment purchase.
To understand equipment financing and leasing, it’s important to understand what is considered “equipment”. In terms of equipment financing—it’s more than just a construction loan; or a loan to buy construction equipment. Any tangible asset, other than property or a building, used in the operation of a business may be considered business equipment. For example, desks for an expanding office, a pizza oven in an Italian restaurant, a dental X-ray machine, as well as a large milling machine or construction implement, may all qualify as business equipment.
Many businesses choose to finance the purchase of expensive equipment to spread the cost over the useful life of the asset, making the purchase more accessible. There are also times when a business will choose to finance the purchase of equipment, to free up capital to invest in other areas of the business. As a result, equipment financing can be a useful tool.
There are two options available for financing new equipment for a business:
1 Equipment Leasing
2 Equipment Financing
Here are some important things you need to know about each financing type to help you determine which will make the most sense for your small business.
Leasing is similar to borrowing, however in a lease, it’s the lender that purchases the equipment and then leases (rents) it back to you for a flat monthly fee—sometimes lower than the payment on a loan would be. Most equipment leases come with a fixed interest rate and fixed term, but interest rates and terms can vary depending upon the leasing company and your credit profile. You can expect to see anywhere from high single digits to double digits, so it makes sense to shop around before you commit. At the end of the lease, you may be able to purchase the equipment at fair market value, or a predetermined amount—sometimes for as little as $1, depending upon the lease.
How Does Leasing Work?
Many equipment dealers offer equipment leasing through an in-house leasing department or work with other leasing companies they recommend. This can streamline the application process and make leasing equipment very convenient.
A lease is not a loan, so it does not appear on your credit report as a loan. Nevertheless, like a loan, standard lease terms can include three, seven, or even 10 years. Additionally, your lease payment might even be deductible as a business expense (this is something you should consult with your tax advisor about).
Although the lease doesn’t appear on you credit profile as a loan, your timely payments will likely be reflected on your business credit profile the same as any other revolving debt—provided the leasing company reports to the business credit bureaus (which it probably does).
Although there is no hard and fast rule for what type of equipment is best suited to a lease vs. a purchase, there are some types of equipment that could make more sense for a lease because of the shorter usable life of the equipment:
- High-tech computers
- Some medical equipment
- And equipment that gets a lot of wear and tear
The Pros and Cons of Leasing
- Leases are sometimes easier to qualify for than a traditional term loan
- Leases often include more flexible terms when compared with an equipment loan
- Some leases can be obtained without any down payment
- You may be able to include lease terms allowing for the exchange or upgrading equipment over a certain period of time in some situations
- The full amount of the lease payment in some instances may be tax deductible, vs. only the interest on an equipment loan (be sure to consult with your tax advisor)
- In some situations, a lease can cost more than a loan
- You will likely need to continue making lease payments even if your need for the equipment ends before the lease term expires
- The entire amount of your lease payment may not be tax deductible if your lease terms include any provision allowing you to own the equipment at the end of the lease
Equipment loans can come from a variety of sources depending upon your credit worthiness and the nature of the equipment being purchased. These sources could include:
- Commercial banks
- Credit unions
- Online lenders
- Government-backed SBA loans
Depending upon the nature of the equipment. In a construction equipment loan, for example, the equipment itself can sometimes be used for collateralizing the loan. And, depending upon the type and cost of the equipment being purchased, equipment loans can sometimes be for smaller amounts than a typical bank loan; which could make traditional financing an option for qualified small business borrowers.
Terms for equipment loans vary depending upon the individual lender. Commercial loan repayment terms tend to max out at seven years for most loans with interest rates that will also vary depending upon the lender, your credit profile, and the amount borrower.
To qualify for an equipment loan at the credit union, you will need to be a member to apply.
Online lenders also offer financing that is suited to purchasing equipment; and similar to what is described above for traditional lenders, rates and terms will vary depending on the individual lender you choose. Although interest rates could be higher, a quick response is a hallmark of online lenders—often responding to a loan application with an hour and depositing funds in your business bank account within a day or two. Sometimes as quickly as within 24 hours.
While loan terms will differ, depending upon the lender, most traditional lenders will ask for a down payment, likely 20 percent of the loan upfront. An SBA 504 loan will require a 10 percent down payment. As with most loans, the interest on an equipment loan is tax deductible.
How to Apply
As with any business loan, make sure you have the documents needed for the particular lender where you’ll be applying. The requirements for traditional lenders and online lenders are different, so the amount and type of documentation will vary depending upon the lender. For example, a loan at the bank may require a business plan while an online loan likely will not.
If you are seeking a loan at the bank, you will meet with a loan officer at the local branch. If you are working through the equipment dealer, they will likely be able to handle your application on site. If you pursue an online loan, that application will take place via their online website and possibly a phone call.
Whether you decide to purchase or lease business equipment, it makes sense to make sure you completely understand the terms and costs. Always take the time to read the fine print and make sure anything unfamiliar or difficult to understand is explained to you.