Equipment Financing: How Does It Work?

Equipment Financing: How Does It Work?

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If you're a small business owner you understand how important it is to quickly and economically obtain, upgrade or replace the equipment you need to perform your daily tasks. Purchasing equipment outright can put substantial strain on your cash flow, but equipment financing can be a good solution to keep your business functioning at its best or even to expand to meet increasing demand.

We'll provide an overview of how equipment financing works, the rates and terms you can expect in today’s marketplace, the basic qualifications for these loans and where you can obtain such a loan.

How does equipment financing work?

Equipment financing refers to a loan used to purchase business-related equipment, such as a restaurant oven, vehicle or copy machine. When you take out an equipment loan, you'll need to make periodic payments that include interest and principal over a fixed term.

As security for the loan, the lender may require a lien on the equipment as collateral against your debt, similar to how an auto loan works. Once the loan is paid in full, you own the equipment free of any lien. The lender may also impose a lien upon some of your other business assets or require a personal guarantee. If you fail to repay your loan, the lender could repossess your business assets, and even your personal assets if you gave a personal guarantee. You'll need to carefully review the loan terms to understand your risk.

For example, if you're opening up a restaurant, you'll need a significant amount of equipment like a commercial range, ovens and a refrigerator. Let’s say the equipment costs total of $75,000: You apply and are approved for an equipment loan equal to 80% of the equipment’s cost, or $60,000.

This means your out-of-pocket expenses will be $15,000, and you can retain $60,000 in your cash reserves to offset all the other costs associated with a new business including marketing and advertising, permits and licenses and the cost of the space.

Equipment leasing

Equipment leasing, on the other hand, is where you pay the owner of the equipment periodic rent for use of the equipment over an agreed-upon period of time. The equipment is returned to the owner at the end of the leasing term, unless you both agree on renewal terms or a buyout.

Generally, the qualifications for leasing are less strict than for financing. However, if the equipment is necessary to your business, the endless payments on leased equipment without the prospect of future outright ownership may be a more costly option.

Equipment financing rates and terms

As with all financing, rates and terms will vary depending on your qualifications and the current market conditions. Below are some sample equipment financing rates and terms you can expect when shopping for an equipment loan.

Loan to value ratio
Up to 100%
Fixed interest rates2.00% to 20.00%
Repayment terms1 to 25 years
Funding speedAs little as 2 business days
Other requirementsMay have minimum credit score or operating history requirements.

Qualifying for an equipment loan

Lenders will vary in their requirements to obtain an equipment loan. The following are general qualifications that lenders will look at when making a credit decision. However, underwriting standards vary and should be vetted before choosing a lender to ensure you meet their minimum requirements.

Your personal and business credit scores will be an important factor in obtaining equipment loans. If you’re unsure of your current credit score, you can find your personal and business credit scores online. The higher your scores, the more likely you are to get approved with better loan terms.

In addition to credit score, lenders may require a business plan that describes your business and a detailed proposal for future growth. The basic goal is to give prospective lenders a comprehensive summary of your business. The number of years you've been in business and the annual revenue of your enterprise are important factors to include within your business plan. Some lenders may have threshold requirements in this regard, such as a minimum of two years in business with annual revenues of over $250,000.

Beyond a profit and loss statement, lenders may also require a balance sheet or cash flow statement. These should identify the revenue coming into the business and the expenses going out. These statements help lenders assess the financial strength of your business.

Since lenders are also interested in your personal finances, you may need to include some personal documents as well. This might include items like past tax returns, bank statements or a list of all your personal debts.

Equipment financing pros and cons

Here's a brief summary of the different factors you'll need to consider if you're thinking about financing equipment for your business:

Pros of equipment financing

  • Can help you build business credit
  • Can be an affordable option, especially if you opt for a secured loan
  • Can allow you to get the equipment you need for your business in order to grow

Cons of equipment financing

  • More expensive than saving up to buy the equipment outright
  • Payments can be a hindrance on your business cash flow until the loan is paid off
  • Can seriously damage your credit or even put you out of business if you can't make the payments

Where to get equipment loans

There are several options available in the marketplace for obtaining equipment financing — ranging from traditional nationwide bank lenders to smaller specialized online lenders.

Traditional bank lenders may have stricter underwriting requirements, but also better rates and terms. They may be more suitable to established businesses with strong cash flow and assets.

Specialized online lenders, on the other hand, tend to be more flexible with their underwriting requirements. However, the rates and terms may not be as good as those from a traditional bank lender.

This type of lender is more suitable to startups or businesses that don’t meet the minimum credit and asset requirements of bank lenders. However, the best option for you depends on where you're at in your business journey, and whether you prefer better rates over faster and more flexible service.

It's important to know that an equipment loan isn't your only option when it comes to raising funds for your business. If you're buying relatively affordable equipment, you could also consider a business credit card, invoice factoring, merchant cash advance or angel investing. Each have their pros and cons regarding terms, turnaround time and qualification requirements.