All businesses need some type of equipment, but often, businesses don’t have enough cash to buy it on the spot. This is where equipment leasing and equipment financing come in to play. Both of these options can get the business owner and the business the things it needs to succeed, but they work in slightly different ways. You, the business owner, have to decide which one will work best for your business’s particular need(s).
Equipment leasing and equipment financing (otherwise referred to as equipment loans) are different mostly in the ownership aspect of things. Equipment leasing allows you to rent equipment from the vendor for a monthly payment, but you don’t actually own the equipment during the lease term. Equipment finance is a collateralized loan that allows you to purchase the equipment. Once you’ve completely repaid your loan, you fully own your equipment; it’s yours to keep.
How does equipment leasing work?
You may be more familiar with the word “lease” from things like car and apartment leases. Equipment leasing is a similar concept, but instead of a car or apartment, it’s a piece of equipment for your business. If it helps, you can think of leasing as renting. You’re accountable for monthly payments on the rental until the end of your leasing agreement.
Once you've reached the end of the initial lease agreement, you have the option to renew or terminate the lease. In some cases, you may have the option to purchase the equipment you’ve been leasing for its market value.
Alternatively, leasing has several disadvantages which we’ll get in to later. One of the biggest disadvantages to leasing is that it can be notably more costly than simply purchasing the equipment outright. That being said, if your business is quickly expanding or in an industry with a high equipment turnover rate, then leasing is a good idea.
How does equipment financing work?
Equipment financing (or an equipment loan) helps business owners pay for a piece of equipment over an extended period. This financing option is ideal for durable pieces of equipment that hold their value over a long period and won’t need to be replaced by newer equipment anytime soon. It’s important to note that if what you're buying with your loan becomes obsolete, the loan won't be affected. So, if this occurs, you might be paying for a piece of equipment that is outdated and no longer benefits you. If a lender approves your application, they’ll spot you nearly or all of the cash you need to buy your business equipment.
After you receive your cash sum, you’ll repay that loan amount with interest over a previously stipulated period of time. The length of the equipment is of value will partly dictate the term length of the loan. Once the loan is paid off in full, you own it and it’s yours to keep.
Pros of equipment leasing
Low Monthly Costs
An equipment lease allows you to rent a piece of equipment that you can't afford to buy right on the spot. Often, lenders won’t require any upfront payments, and the monthly rate is usually lower than what you would see compared to that of a business line of credit or loan.
If you're in a field with a high turnover rate for technology, it doesn't make financial sense to keep replacing it every few years. If you find that you're in constant need of equipment upgrades, leasing is likely a better option than a business loan or purchasing outright.
Depending on the lender’s terms, you may be able to return a dated piece of equipment at the end of your term, and start another lease on a newer piece of equipment. This would be instead of just buying the equipment at the end of your lease term.
Sometimes, accidents happen or things break down. Fortunately, with an equipment lease, the leasing company will almost always take care of any repairs on the piece of equipment.
As a business owner, you probably want access to as much working capital as possible. A lease doesn't typically require a down payment, so you will have more cash on hand to pay your day-to-day bills.
Simple Application Process
Another great feature of equipment leasing is the application process. You probably won’t need to provide as much financial paperwork as you would if you applied for a traditional loan. Also, equipment financing has options for those with less-than-stellar credit.
Equipment Leasing Cons
The good news is that with an equipment lease, you won’t pay interest on monthly payments. The not-so-good news is that business lenders will include an effective interest rate in to the monthly payments. So, this makes these monthly payments a little pricey.
As we’ve discussed before, your personal and business credit score, business’s age, its annual revenue, and outstanding debts all play big roles in dictating the terms of your equipment lease and your monthly payments. That said, lenders determine the cost mainly by the value of the equipment they’re buying and how well it will hold its value.
Equipment Financing Pros
No Strenuous Qualification Standards
Equipment loans are easier to qualify for, compared to traditional term loans. Additionally, most equipment lenders will consider business owners with less-than-stellar credit scores. Lenders can take more of a risk like this because equipment loans are self-collateralized. So, if a borrower is unable to make their payments and defaults, then the business lender can repossess the equipment (that they’re financing) and liquidate it to retrieve their lost money. The fact that lenders have a preventative measure preset in place allows them to be less discerning when lending to businesses.
Most business loans require a borrower to have an asset of value to be used as collateral to secure the loan. With equipment loans, the equipment itself is used as collateral, so in most cases, the borrower is not required to provide anything else. Small businesses may find this advantageous, as they might not be able to own the types of assets lenders typically look for to be used as collateral for loans.
Since equipment financing comes with collateral as an intrinsic stipulation, lenders can be more flexible about approving applicants. Your business’s credit score is a lesser factor; therefore, lenders are virtually just as likely to approve a younger company as they would be to approve an older one with more experience. Also, applying for equipment financing features less paperwork than applying for a regular business loan, so the application and approval processes are usually quick.
With equipment loans, lenders require you to pay interest along with the principal amount of the loan. As we’ve previously discussed, there’s no one average interest rate, but rates for equipment financing can be anywhere from 8 to 30 percent. As we also mentioned before, equipment loans are longer-term, so as one might expect, the long-term cost of an equipment loan is lower than that of a lease.
Financing is often entirely tax deductible for small business owners, and $500,000 is the recent maximum tax deduction for equipment loans. That could potentially be the whole cost of your product!
The lender probably won’t ask you to provide any additional collateral to secure your loan because equipment loans have preset, conditional collateral.
Equipment Finance Cons
If a lender approves you for an equipment loan, they’ll likely only supply around 80 percent of the amount of the equipment, which means you have to pay for the remainder upfront. It’s less likely that they’ll pay 100 percent of it right off the bat. That being said, if you are able to pay a large down payment, you’ll have a good chance at having a lowered interest rate. The lender views you as less of a risk if you have the financial means to pay a lot upfront.
The Equipment is Yours, Whether You Like it or Not
Before you apply for a loan to buy a specific piece of equipment, be sure that it won’t depreciate in value toward the end of your term. If you go in without knowing, you could be tethered to an outdated piece of equipment. This will likely be costly to get rid of and inefficient for your business.
The Bottom Line
So now that we’ve defined what equipment leasing and equipment financing are, and discussed their pros and cons, you might be wondering which option to pick. The main things to consider are how quickly the piece of equipment will need to be updated, and perhaps more importantly, how much money you have. If you basically break the two options down in to monetary and timeline aspects, you can then apply those to your business’s particular situation and see which is more appropriate.