The Small Business Owner’s Guide to Equipment Financing
By Michael Jones, Director of Community Development
Equipment financing can take several different forms and what's appropriate for one business may not be for another. After reading this guide, you'll have a better understanding of:
• How equipment financing works
• How the different financing methods compare
• What the pros and cons are for each one
What is equipment financing?
Equipment financing is designed specifically for the purchase of business equipment. Your business makes payments towards what you borrow over time and once the debt is repaid, you own the equipment free and clear. With certain types of equipment financing, the equipment itself serves as collateral so that if you default, the lender assumes ownership.
Depending on how the financing agreement is structured, the lender may impose a blanket lien or require a personal guarantee. A blanket lien allows the lender to lay claim to your business assets, including the equipment itself if you default. A personal guarantee does the same with regard to your personal assets so it's important to understand what you're agreeing to before you borrow.
Equipment financing vs. leasing
When you need equipment, you don't necessarily have to buy it–you could lease it instead. This means you're essentially paying the equipment's owner rent each month just as you would if you were leasing office or retail space for your business. At the end of the lease term, you can choose to renew your agreement or you may even be able to buy the equipment outright.
Leasing offers an advantage over financing in that you're not required to offer any sort of down payment to obtain the equipment the way you might be expected to with a loan. Generally, you're not bound by any collateral, lien or personal guarantee requirements. It may also be easier to qualify for a leasing arrangement than financing if your business or personal credit are less than stellar.
There is a potential drawback, however, in terms of the cost difference. Leasing equipment over the long-term means you're not locked in as far as ownership but you could end up paying more to rent than you would by purchasing the equipment instead.
Equipment financing: What are the options?
Small business owners have multiple financing avenues they can use to get the equipment they need. Deciding which one is the best fit ultimately depends on several factors, including:
• Your personal and business credit scores
• How long you've been in business
• Your annual business revenues
• The desired loan amount
• Your preferred repayment terms
With that in mind, here's a look at five viable ways to finance equipment:
1. Equipment loans
Best for: Newer businesses that need equipment financing to expand operations
An equipment loan most closely parallels the definition of equipment financing mentioned earlier. The equipment acts as collateral for the loan and it's possible to get up to 100% financing, although some lenders may require a 20% down payment.
Repayment periods can be as short as 36 months or stretch out over a period of 10 years or more, based on how much you're borrowing. Loan limits can go as high as $500,000 and the annual percentage rate for equipment loans is somewhere between 8% and 30%.
On the plus side, equipment loans can be funded fairly quickly, often in as little as two business days. Since many equipment loan and term loan providers operate within the online sphere only, rather than having a physical location, underwriting is often much more streamlined. It's possible to fill out an application, upload documents such as financial statements or tax records and get an approval decision within 24 hours or less. With a traditional bank, you may be waiting days or even weeks for your application to go through underwriting. Perfect credit isn't a requirement of obtaining an equipment loan. Lenders do, however, usually require you to be in business for at least one year before applying so you may have a tougher time qualifying if you're still in the startup phase.
2. Term loans
Best for: Established businesses with consistent revenue that want to borrow up to $500,000
Term loans are another possibility for small business owners who need quick access to cash for an equipment purchase. As the name suggests, term loans are repaid over a set period of time similar to a mortgage or car loan. Annual percentage rates are comparable to those associated with equipment loans and they may be fixed or variable.
Term loans can be secured or unsecured, based on how much you're borrowing. If you don't want to use the equipment as collateral, you may have to offer up another business asset as a substitute.
Term loan lenders can have higher credit standards than equipment loans. For instance, it's possible to get an equipment loan with a credit score as low as 600. To qualify for a term loan from Bond Street, on the other hand, you'd need to have at least two years of operating history, be generating at least $200,000 in revenue annually and have a personal credit score of 660 or better.
While the approval standards may appear tougher, that can work to your advantage if you're able to leverage a higher credit score to qualify for a lower interest rate. You may also be able to snag a lower origination fee, which can reduce the cost of borrowing even further. A difference of even one percentage point, either in the APR or the origination fee, could save you thousands over the course of the loan repayment term.
Like equipment loans, it's possible to receive the funds in just a few days thanks to the streamlined application and approval process that online lenders like Bond Street offer. That efficiency is yet another reason why a term loan may be a more attractive option than one of the alternatives for business owners with a strong credit history.
3. Small Business Administration CDC/504 loans
Best for: SBA-eligible businesses that need to borrow up to $5.5 million to buy equipment
The Small Business Administration offers several loan programs geared towards small business owners and the CDC(Certified Development Company)/504 Program can be used to cover equipment purchases. This program is open to for-profit businesses that have a tangible net worth of less than $15 million and after-tax revenues of less than $5 million for the previous two years.
In contrast with equipment or term loans, the CDC/504 loan offers more generous loan limits. Eligible businesses can get up to $5.5 million in financing, with loan terms extending up to 20 years. The equipment serves as collateral and a personal guarantee is also required.
The interest rate for these loans is determined by the current market rate for 5-year and 10-year U.S. Treasury issues. Currently, the effective rate for one of these loans is around 4.25%, which is lower than the rates associated with some of the other options profiled here.
Business owners will also pay a fee totaling 3% of the loan amount. If you're borrowing the full $5.5 million allowed, the fee alone would add $165,000 to the cost. In terms of the percentage, however, that's on par with what other lenders charge for equipment or term loans.
Of all five options, the 504 loan has the longest time horizon for funding. It can take up to 8 weeks for a business to complete the various stages of the application and approval process and receive the loan proceeds. That's a significant disadvantage if you need to purchase equipment in a hurry.
4. Small business line of credit
Best for: Businesses that want fast, flexible equipment funding
A business line of credit is similar to a personal or home equity line of credit in that the bank makes a certain amount of money available to you that you can draw on again and again. It's possible to obtain a line of credit of up to $1 million if you own an established business that has a solid track record and you've got an outstanding credit score.
Business lines of credit can be repaid over a period of a few months or have terms that stretch out up to five years. Funding can be completed in a matter of days and a lower credit score generally isn't a major roadblock to approval. It does, however, mean you'll pay more in interest.
That's where business lines of credit lose some of their luster compared to other financing choices when you need to buy equipment. Rates can easily be in the neighborhood of 36%, which can make your equipment much more expensive over time. That's because a business line of credit is designed to be used in the short-term to cover temporary cash flow gaps rather than large, one-time expenses.
For instance, you could draw on your line of credit to cover payroll one month and pay it back the next or use it to stock up on inventory when business is slow. While a line of credit can offer easy access to cash for an equipment purchase, that convenience often comes at a cost in the form of a higher interest rate.
5. Business credit card
Best for: Business owners who want to earn rewards for small equipment purchases
Of the financing options outlined here, business credit cards normally have the lowest credit limits, with $100,000 generally being the ceiling. That doesn't mean, however, that business owners should count them out completely when they need to buy equipment.
The main advantage of using a credit card for equipment is the ability to earn points, cash back or travel miles for your business. If you have a card that pays 3% cash back, for example, and you use it to charge a $15,000 oven for your restaurant, you'd effectively be getting a $450 discount. That's something you wouldn't find with another financing route.
Among the biggest downsides are the interest rates and fees. Credit card APRs quite often run in the double-digits and it's not uncommon for a rewards card to charge an annual fee. If you're not able to pay the purchase off within a relatively short time frame, the interest could outweigh the value of any rewards you're earning.
You also may run into issues if you're dealing with an equipment vendor that doesn't accept credit card payments because of merchant fees. If the vendor does allow you to pay with plastic, they may pass the cost on to you which again, could make a credit card more expensive than say, a term loan.
Weigh your options carefully
When researching equipment financing, there are several things to pay attention to help you narrow down which path you should choose. First, consider the total cost of borrowing. A low interest rate may be appealing but you also have to look at whether you'll pay a loan origination fee or an annual maintenance fee, which could drive up the overall cost, which is why it's better to focus on the APR which is inclusive of all fees associated with a loan.
Next, factor in the repayment terms. A shorter term means the debt is repaid faster but it may entail a higher monthly payment. Opting for a longer term would lower the payments, resulting in less strain on your monthly cash flow but it could increase the interest total once you've paid for the equipment in full.
Finally, review the approval conditions established by the lender. You need to be sure that you meet the minimum guidelines where credit scores, time in business and annual revenues are concerned. You should also be aware of whether a down payment or collateral other than the equipment is required and what the lender's policy is regarding personal guarantees or liens.