When you need equipment to keep your business running or to upgrade existing machinery to increase productivity, asset-backed funding is worth considering. Equipment loans are often easier to secure than traditional term loans and can help protect your cash flow by allowing for the slow payment of an asset over time. Learn the pros and cons of equipment financing and the ways in which it can be beneficial for businesses at any stage.
How Equipment Financing Works
Equipment loans can be useful when you’re looking for a specific type of funding for your business. With this type of loan, the business often pays a variable down payment followed by monthly payments toward the equipment loan. In this case, the machinery often serves as the main collateral for the loan, although some additional collateral may be required depending on the credit worthiness of the business and its owners. Assuming there is no default, at the end of the term, the business owns the piece of equipment. Equipment loans are available from various lenders, credit unions, and large banks, through the Small Business Administration (SBA), and sometimes through the equipment manufacturer directly. Rates, terms, and qualifications for equipment loans vary between lenders, although most equipment loan terms average three to seven years. Some may require personal guarantees, pledged assets, or down payments depending on the loan-to-value (LTV) ratio. The LTV ratio is the borrowed amount divided by the value of the asset, and is typically set by the lender. Traditional lenders may set stricter LTV ratios depending on the health and age of your business, which means your business would be required to pay a larger down payment, sometimes more than 20%. Due to variable LTV ratios and interest rates, offering a larger down payment could increase your chances for equipment loan approval. A large, built-in piece of collateral can often mean an easier path to approval versus traditional business loans, so equipment financing is a popular route for businesses of all sizes looking to upgrade their process without sacrificing cash flow.
Equipment Financing vs. Equipment Leasing
Equipment financing is not the only way to add new machinery to your business. If you’re looking to avoid some of the more cumbersome loan qualifications, equipment leasing may be worth considering. With leasing, a business essentially rents a piece of equipment from the lender or, in some cases, directly from the manufacturer for a specified amount of time. Equipment leasing generally does not require a down payment or any additional collateral requirements outside of the piece of equipment. Monthly lease payments are often lower than an equipment loan, and because the business does not own the piece of machinery, the onus for repairs, upgrades, and, in some cases, regular maintenance lies with the lender. This can be a huge benefit for small businesses who can’t afford to fix and replace key assets that see a lot of wear and tear. Certain equipment leases, such as a capital lease, may offer the business the opportunity to buy the equipment at the end of the lease for fair market value. Because equipment leasing is technically a rental, however, the business may not take advantage of the depreciation benefits of asset ownership afforded by Section 179, which allows 100% of purchase price of property to be deducted.
Pros and Cons of Equipment Loans
Pros Explained
Improve efficiency: Many businesses need equipment in order to become more efficient, lower cost of goods sold (COGS), or streamline production practices to grow substantially. Securing loan funding for specific equipment can help upgrade your business practices and allow access to machinery that otherwise might take years to buy outright. Protect cash flow: Purchasing equipment can be very costly, especially for a small business. Financing key pieces that allow a business to take the next step can be a lucrative way to protect cash flow while still promoting growth. Easy approval: Since an equipment loan includes a large piece of collateral, approvals are often easier to secure than for a general small business term loan. There can be less paperwork, more favorable terms, and often quicker turnaround times—all of which benefit a small business looking to grow. Increased assets: As opposed to an equipment lease, with an equipment loan, the borrower holds the title to the equipment and is able to claim ownership on the machinery throughout the loan term. At the end of the term, assuming there was no default, the business will have gained an asset, which can be used as collateral to obtain better financing in the future.
Cons Explained
Major debt obligation: As with any loan, taking on an equipment loan comes with a great deal of risk. Equipment is expensive, and adding that debt to your business may not be the right choice. If you are unable to meet your monthly payment obligations, the equipment will be seized, as will any other assets that may have been pledged to secure approval. Outdated equipment: Loan terms will often last as long as the piece of equipment lasts, since the lender needs to be assured there will be something of value left to seize in the case of default. Similarly, if your business practices change, or new equipment comes to market that better suits your production, you will be required to pay off a piece of equipment that no longer serves your business’s growth goals. Increased liabilities: If your business is young, or has little or bad credit, some lenders may require a UCC blanket lien in addition to securing the piece of equipment as collateral. This means that if you default on the loan, the lender may have the right to seize additional business assets to recover the lost funds.
Where To Get an Equipment Loan
Because they are backed by securable collateral, equipment loans are relatively common and are offered by various lenders. Large banks, local credit unions, and alternative lenders all offer equipment financing for businesses. The loan limits, terms, and rates vary according to the lender, and are influenced by the creditworthiness of the business and its owners. The ease of application also depends on the type of institution. Traditional banks are likely to require more information and have a longer application process, but may have more favorable rates compared to online lenders, which can turn around applications much quicker but tend to charge higher interest.
SBA Options
Many small businesses turn to the SBA for business loans of all types, including equipment loans. The SBA’s 504 program offers equipment loans of up to $5 million for businesses that meet the criteria. Businesses must be for-profit, have a net worth of less than $15 million, and have an average income of less than $5 million for the two years preceding the application. The SBA partners with authorized lenders to back a portion of the loan, making it easier for a small business to secure funding. 504 loans are often available for up to 90% of the purchase cost of a qualified piece of equipment, and terms range between 10 and 20 years.
How To Get an Equipment Loan
Before starting the process for applying for any type of funding, it’s important to research what works for your business. Once you’ve decided on the right loan path, the next rule of thumb is to have as much information gathered for your application before beginning. This will help the process go smoothly and increase your odds of approval.
Credit: Be ready to provide your personal credit score, as well as that of your business. Higher business credit scores have a better chance of being approved for an equipment loan with more favorable terms and rates. Understand the equipment: Have a clear understanding of how the equipment will benefit your business. Come prepared with business plans and projections, as well as detailed information about the specific equipment, its projected value, its current value, and quotes from various manufacturers, if applicable. Basic information: Make sure you’ve gathered the appropriate business information, including background on owners, basic tax information, credit reports, and tax returns for owners and the business. Financial statements: Lenders will want to see tax returns as well as financial statements for your business for the past two years. Revenues and business history may determine the rates or any additional collateral for the loan, as well as eligibility for the SBA 504 program. Don’t send out too many applications: After doing the proper research, try to avoid sending out loan applications to too many potential lenders. It will lead to questions about your viability as an applicant.
