The mechanics of business equipment loans
Basics of business equipment loan
- For some borrowers, leasing may be better than borrowing.
- Established businesses have a big advantage over startups.
- Lenders want to know business cash flow and the value of the machinery.
- Bank loans are the most economical, but also hardest to get.
- SBA guarantees give banks an incentive to make loans.
Purchasing equipment is one of the biggest expenses you encounter while operating a small business, whether you’re buying specialized manufacturing machinery or basic office furniture. There are as many equipment needs as there are types of businesses. New businesses need equipment to get their operations up and running, and existing businesses have to plan for the replacement of aging equipment.
A few business owners have deep enough pockets to buy equipment outright. For the rest, one of the first decisions is whether to buy or lease equipment. The factors that govern that decision are, in some ways, similar to those you would consider when deciding whether to lease or buy a new car. Lease payments can be lower than loan payments, but borrowing money gives you the opportunity to eventually own the equipment.
If you're funding a startup, lenders may make the decision for you. They favor established businesses, and offer pricey equipment funding to new companies, if they offer any funding at all.
A startup might find nonbank institutions willing to lend the money, but interest rates could be astronomical — 30 percent or higher. That's in addition to requiring that a business owner’s home or the company’s accounts receivable be pledged as collateral. If the expenses and paperwork are too onerous, leasing might make more sense, or lease-to-buy arrangements may be available.
Interest rates are lower and lending standards looser if you have an established business. Although troublesome credit ratings are not necessarily deal killers, the better your credit history and demonstrated business skill, the greater your options for an equipment loan. You'll have more lenders to choose from if you go in with a clean, bankruptcy-free credit history. As with other types of commercial loans, banks typically offer the best terms for equipment loans, but are more likely to want to see your business plan and examine years of business financial statements.
Specifically, lenders will want documentation of your business' cash flow and proof of your ability to repay the loan. They also will be interested in the equipment itself and its value as collateral should you default on the loan.
You'll probably be asked to provide at least two years of tax statements for your business when you apply for a loan. A nonbank lender might not want much more than that, while a bank also could ask for personal tax returns and income statements covering a longer period of years.
If you can document that your business is a robust operation that's been operating for an extended period, you might qualify for a bank loan with single-digit interest rate, along with lower origination fees and better prepayment conditions than you're likely to get from nonbanks.
Among the bank offerings are particularly attractive loans guaranteed by the U.S. Small Business Administration (SBA). Under the SBA's 7(a) program, for instance, loans of up to $5 million are partially guaranteed, eliminating much of a bank’s risk and creating an incentive for the lender to make the loan. Although the SBA leaves most of the loan details to participating banks, it requires that the institutions charge interest rates of no more than 2.75 percent above the prime rate. The average loan amount under the program was $371,000 in 2015.
The length of the loan is an important consideration. The longer the loan term, the higher the interest rate you can expect to pay on an equipment loan. Your monthly payments might be lower if you land a longer-term loan. But you also don't want to be paying off a loan long after your equipment has worn out or becomes obsolete, so it pays to know the expected useful life of the equipment and be careful to assure the loan term does not exceed that time frame.
Finally, no matter what type of lender you end up doing business with, it pays to shop around. In addition to loan sizes and loan terms, learn the areas of expertise developed by prospective lenders. Banks advertise their specialties, such as health care equipment or commercial vehicles, as well as the types of loans they won't touch. Knowing that information in advance can be an advantage, or at least keep you from wasting your time with a reticent lender.