What Is Equipment Financing?
Equipment financing, also called an equipment loan, is a type of small business loan designed for the purpose of buying machinery or vehicles. It provides small business owners capital to purchase new or used equipment needed to run their companies. You can take out equipment loans for a wide array of purchases, such as medical equipment, farm vehicles, or computer equipment.
The process to get an equipment loan is quick. Both traditional banks and online lenders offer this loan option. But although banks generally offer more favorable interest rates and terms, they also have strict credit requirements.
The amount you qualify for will depend on the purchase price of the machinery, but you might be able to finance up to 100% of the equipment's value. The length of the loan term will also depend on the expected life of the equipment.
With equipment financing, the machinery you're purchasing serves as collateral for the loan. This means the lender can seize it if you fail to repay the loan. Some lenders may also require a personal guarantee, or they may use a blanket lien to lay claim on your assets in case you default.
This is why it's important to understand the rules of your contract no matter what type of financing you're getting into. Make sure you know the penalties in place in case you can't fulfill your obligations.
What Can You Use Equipment Financing for?
You can use equipment financing to buy or lease any new or used equipment you need to operate your business. The lender will loan you a percentage of the full value of the piece of equipment. Once you've paid off your loan, you own the machinery free and clear.
Most small business owners take out equipment loans to purchase specialized machinery, like tractors, X-ray machines, and delivery trucks. Businesses may also use equipment financing to acquire intangible assets, like business-related software.
Here are some common uses for equipment financing:
- Computers
- Restaurant needs, such as industrial ovens
- Health care equipment
- Office furniture and supplies
- Heavy equipment
- Manufacturing machinery and parts
- Construction equipment
- Farming equipment
- Vehicles and other transportation needs
- Project management software and similar technology
- HVAC units
How Is Equipment Financing Different From Leasing?
The main difference between equipment financing and leasing is who owns it. When you lease, you pay the vendor for the privilege of using the equipment for the duration of the lease term. You don't own the asset and you return it at the end of the term.
On the other hand, equipment loans allow you to purchase the piece of equipment outright with the machinery itself as collateral. Once you've paid off your loan, you own the equipment free and clear.
Leasing a piece of equipment is comparable to renting an apartment, while equipment financing can be compared to buying a house with a mortgage. Some reasons small business owners lease equipment include:
The requirements for leasing are less strict and the application process is more straightforward than for financing.
Leasing doesn't require any money down or additional collateral, which means there's no cash outlay for the business to acquire the asset. It also doesn't risk any personal or business assets to secure the lease agreement.
Since you're renting the equipment, the vendor or the leasing company is responsible for any repairs or replacements if the equipment breaks down.
Leasing agreements can be flexible — you can decide to renew the lease, return the equipment, or buy it.
At the end of a lease term, you also have the option to lease a new, updated version of the equipment. This is a significant advantage for equipment like computers, which can quickly become outdated.
The biggest drawback of leasing is, of course, the cost. A business can reduce its business expense during the initial term of the lease because it doesn't need a deposit or down payment. However, it may not be cost-effective for your business to pay monthly interest without the prospect of owning the equipment. This is especially true if the equipment is essential to the operations of your business.
For instance, if you own a bakery and need an industrial oven to make your products, renting the equipment long term may cost you more money than buying it outright. This is why it's recommended that you consider leasing pieces of equipment if you'll only need them for 36 months or less. For machinery you'll use for as long as you're in business, it's a smarter move to buy them outright, and you can utilize equipment financing if you need it.
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How Does Equipment Financing Work?
Equipment financing is a loan that a business owner takes out to purchase equipment necessary to run their business. Commercial and industrial equipment are typically expensive, which means a huge expense for companies. However, most small businesses don't have the working capital to buy business-related equipment outright, so they use equipment financing.
If you've ever had a car loan before, you're already familiar with the overall structure of an equipment loan. The total amount you borrow depends on the type of equipment you need to purchase and whether it's new or pre-owned. Since the funding is secured with the equipment itself, there are no additional collateral requirements to get approved by a lender.
In this type of financing, you get approved for a loan amount depending on the equipment's value or purchase price. Then, you make loan payments that include interest and principal over a fixed term. Most equipment financing interest rates are fixed with monthly payment terms.
As for the loan term, it varies depending on the life of the machinery. It's recommended that you choose a repayment term that's close to how long you expect to use the equipment. For instance, if you're buying an oven for your bakery that you expect to use for seven years, you should get a seven-year term.
This is because if you agree to a shorter loan term, you might have to pay large monthly installments that cost more than you can afford. If you take out a long-term loan, however, you could be paying for the equipment even after you've stopped using it. A longer term than necessary also means more interest payments.
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When Does It Make Sense to Use Equipment Financing?
For business owners in many industries, growth is a direct result of purchasing more equipment. The health care, transportation, and manufacturing industries are business models where growth is achieved through the number of vehicles or machines operating at any time.
What if your plans for growth are more extensive than what your current cash flow allows? How can you afford to buy the needed equipment to reach your goals? Fortunately, that's where equipment financing options come to the rescue. Equipment loans provide the working capital needed to take your business to the next level. For instance, if you're opening a bakery, you may need to rent a space for a storefront and a number of big-ticket items.
You'll need industrial convection ovens, heavy-duty mixers, refrigerators, and display cases, among other things. Let's say the total cost of appliances you need is $60,000. You can apply for an equipment loan and get credit approval for as much as 100% of the total value of the kitchen appliances.
If you can get the full $60,000 as an equipment loan, it means you won't have to shell out any cash for your equipment needs and you can use your available capital to pay for rent, wages, supplies, and other operating expenses.
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