By Emily Starbuck Crone
At some point, most small businesses have to spring for new equipment, but it can be hard to afford such purchases outright -- and even if it's possible, it may not be wise to drain your cash reserves.
Equipment financing is one way businesses of all sizes get the equipment they need. Of U.S. businesses, 72% use some form of financing to obtain equipment, according to the Equipment Leasing and Finance Association.
There are two main financing options -- loans and equipment leases. Before you decide, here are a few points to consider:
1. Your cash flow
Equipment leasing -- in which you essentially rent equipment from the owner or a third party -- usually requires lower monthly payments than a loan, says William G. Sutton, president and CEO of the Equipment Leasing and Finance Association. And it doesn't require a down payment, as is often needed for a loan.
Loans can cost more than leasing, and small businesses typically aren't sitting around with a lot of excess capital, says Chris J. O'Brien, senior vice president and credit manager of Associated Bank.
O'Brien says his bank usually requires the borrower to make a 20% down payment for an equipment loan. The smaller the company, the more precious its capital, O'Brien says. With leasing, he says, businesses can "keep capital available for other initiatives in the business or for emergencies."
Leases, however, are not without risk, notes James Schallheim, finance professor at the University of Utah and author of "Lease or Buy?" As with borrowing, you're taking on a fixed financial obligation.
If you can obtain bank credit to buy equipment outright, he adds, it's probably cheaper in the long run than leasing. There are perks to leasing, however, such as avoiding getting stuck with outdated equipment and, in some lease types, receiving free maintenance.
2. Your assets
Although creditors typically require a 20% down payment on equipment loans, O'Brien says businesses with ample assets or equity may not need to put down as much money -- or any. In some cases, he says, a company may have excess value in its inventory or receivables that is sitting, underutilized, on its balance sheet.
"If they came to us and said, 'I have $1 million of inventory and receivables and want to buy a $500,000 piece of equipment,' we say we'll take a security interest in the assets of the company including the new piece of equipment," O'Brien explains. This means your assets become legal collateral for the loan.
3. Your credit
If you want a traditional term loan to buy the equipment outright, your credit needs to be solid, especially if you want a loan from a bank or credit union. Credit not so hot? The equipment-leasing industry is "a ready market for small companies that can't otherwise get credit," Schallheim says.
Companies that specialize in equipment may have more lenient credit standards than traditional financial institutions, O'Brien says. "Their credit screening is different than a traditional commercial bank, "because they have a high level of comfort that if you don't pay, they can go get that piece of equipment and sell it and get the proceeds back."
If you prefer to obtain equipment using a loan but have less-than-stellar credit, you could turn to online alternative lenders. These lenders may have less rigorous credit criteria than financial institutions, but the annual percentage rates for their products may be higher.
4. Your industry
Equipment financing is ideal for businesses that need large amounts of expensive equipment to operate, Schallheim says. For such businesses, leases are often superior to loans, since taking out such significant loans could quickly exhaust your borrowing capacity, he says.
This applies to the transportation industry, such as those businesses using railroad, trucking, trailer and marine equipment, Schallheim says. Farms, restaurants and high-tech businesses also often need large amounts of expensive equipment. If you're in one of these industries that relies heavily on equipment, leasing may be preferable to taking out large loans.
5. Your timeline
If you need the equipment on a short-term basis, usually less than 36 months, Sutton recommends leasing. If you anticipate needing the same equipment for many years, a loan may be a better option.
Also consider whether the equipment is likely to stay current for many years. If so, buying could be a good option. But if it might become obsolete soon, equipment leasing is better.
Schallheim says there's a reason even medium to large companies often lease a whole computer system: It becomes obsolete so quickly, it's best to give back the equipment after two or three years (and upgrade to newer equipment, if desired). Some lease financing programs allow for upgrades or replacements of technology within the lease term, Sutton says. Many IT and computer leases are also bundled with software and sometimes support, Schallheim says, which isn't usually the case when you buy.
6. Your tax needs
If you buy equipment with a loan, you own the equipment and enjoy its depreciation tax benefit, Sutton says. With a lease, the lessor is the owner of the equipment and gets the tax benefit. This may be passed on to you as a lower monthly rent, and you have the ability to expense the payment. In sum, if the tax benefit is not of great importance to you, leasing may make more sense.
7. Your DIY savvy
If your equipment malfunctions, are you competent enough to fix it yourself -- or do you not mind paying for someone else to fix it? If so, borrowing to buy could work for you. But if fixing equipment is outside your sphere, or you cringe at the idea of maintenance or repair costs, you may be better off with an equipment lease that includes upkeep (this is typically called a bundled lease, Schallheim says). Some leases do not include any maintenance or servicing, so read the fine print carefully to learn what you are and aren't responsible for if you encounter problems with the equipment.
With so many factors at play, including tax implications, Sutton says it's wise to speak to your accountant and consult with financing providers before deciding how you want to obtain equipment.
Emily Starbuck Crone is a staff writer at NerdWallet, a personal finance website. Email: firstname.lastname@example.org. Twitter: @emstarbuck.
To get more information about funding options and compare them for your small business, visit NerdWallet's best business loans page. For free, personalized answers to questions about financing your business, visit the Small Business section of NerdWallet's Ask an Advisor page.
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