Equipment financing is used to purchase all types of commercial or industrial equipment. Typical equipment finance arrangements are for machinery purchases, including grinders, saws, drilling bits, etc., and include bank loans, credit terms, interest rates, and repayment schedules. It can also refer to a line of credit given to an equipment buyer with a promise to repay the loan over time.
In some cases, equipment finance is a much better option than a lease. For one thing, it eliminates the need for a long-term commitment. Also, most equipment financing arrangements stipulate that the buyer pays a down payment, which is often 20 percent of the total cost of the machinery. This level of a down payment is usually tied to the creditworthiness of the purchaser. Equipment buyers can be more comfortable taking out equipment loans, rather than lease commitments.
There are three main types of equipment financing: open end lease structure, revolving line of credit (also known as an operating lease), and different types of capital advances. Different types of equipment finance arrangements have different effects on the ability of the buyer to make payments and accrue interest and/or charges. Some equipment finance arrangements can be used as a line of credit systems, while others can be used as a leasing structure. In this article, we will describe each of these different types and why they are used.
Open End Leases: Open end leases are equipment finance arrangements in which the buyer of the machinery, or his or her lessee, makes payments according to the schedule agreed upon between the buyer and the lender. Usually, the payments are for a set period of time, say one year, with a balloon payment at the end of the contract. The buyer has the option to buy the equipment before the lease period is over. The advantage of this type of financing arrangement is that it can be used by many companies; therefore, many companies can have different financing needs. The disadvantage is that the companies involved in the lease may not necessarily be repeat customers or profitable businesses.
Circumvent Financing: Circumvent financing is a unique form of equipment finance in which the lender does not need to verify the credit history or employ any sort of underwriting process. Instead, a business applying for equipment finance must first obtain a loan against its tangible assets (typically equity). The lender then assumes (or grants) a right to use the asset until the loan is paid off. Once the loan is paid off, the asset then becomes owned by the lender. This arrangement provides businesses with a means to obtain equipment finance while providing them with significant leeway regarding their credit requirements.
Obtaining Business Equipment Finance: One of the most common ways to obtain business equipment financing is to obtain a business loan. Most equipment loans are referred to as business line of credit (or BOC). A business must obtain a loan from a financial institution and must comply with certain criteria (such as paying specified costs and fees) in order to qualify for the loan. To obtain equipment financing through a BOC, a business must first determine if its total assets, including trade-in property, are sufficient to meet its projected short-term cash outlay requirements. If not, a business must obtain a second mortgage or other type of financing to meet its short-term financing needs.
Many business owners make the mistake of only obtaining equipment financing when necessary. A good practice is to obtain equipment financing even when a particular project is not financially feasible. For example, some business owners elect to delay or defer installation of expensive equipment, which can significantly reduce the company’s cash flow and financial outlook. On occasion, business owners use equipment financing to implement long-term cost reductions. Unfortunately, the company may still face significant expense impacts even if the costly equipment is installed at the end of its estimated life.
Some business owners also make the mistake of assuming that they can lease equipment rather than acquire it under their operating lease. Although many equipment leasing contracts specify that the company is responsible for equipment replacement, this responsibility does not always extend to equipment that is sold or leased to third parties. In fact, many of today’s lease purchase agreements explicitly restrict the business owner’s responsibility for costly equipment that is sold or leased to others. For this reason, it is sometimes more cost-effective to obtain equipment financing rather than signing a leasing agreement.