Is an equipment loan the right move?
An office full of computers, tractors to work the fields, x-ray machines and dental chairs, outfitting a restaurant or manufacturing plant… equipment is often the most expensive purchase a business will make and a major investment that impacts cash flow for years to come.
Naturally, it brings up questions and concerns. Should I use cash, instead of financing? Do I apply as a business or use personal credit? Is it a bad idea to max out my line of credit, if the limit will cover the purchase? Do I apply for a standard business loan, a quick online loan, or something else? What criteria are important to the lender?
Understanding how financing works and what is most important to the bank helps the borrower make an educated decision.
Should I get a business or personal loan to buy the equipment?
Whether equipment is purchased with personal or business credit is often determined by liability issues and amount of the purchase. If possible, it’s best to apply for a business loan to shift liability onto the business, leaving personal assets out of the equation.
Using a personal loan for high-ticket business equipment puts the borrower’s home at risk if the business defaults on payments. They are personally liable for the loan. And what if the borrower decides to purchase a larger home several years down the road, or open a home equity line of credit to replace the roof? They can’t. The large equipment purchase pushed their debt-to-income ratio to the ceiling and there’s no room for another loan.
Liability aside, expensive equipment loans often exceed the limitations of how much someone can borrow using personal credit. If their personal credit history allows a loan up to $30,000 but the equipment will cost more than that, for example, it’s time to explore financing as a business. Assuming they can qualify, it opens the door to borrowing much larger amounts of money.
What is an equipment loan & why is it different?
There is an important distinction between “a loan used to buy equipment” versus “an equipment loan.” An experienced right financing banker can guide the borrower through their options. They have a variety of SBA, USDA and conventional loan packaging choices available, compared to a slim selection of product choices offered by non-bank lenders. Many different types of loans allow the borrower to purchase equipment, and finding the right one can require a deep dive into business operations and finances to find the ideal fit.
The distinction of “an equipment loan” typically means a loan that allows the equipment itself to be used as collateral for the loan. If it goes into default, the equipment may be repossessed, but the borrower cannot lose their home or other personal assets. The business is liable, not the person.
If the loan amount is extremely large, a secondary business asset may be required to secure the loan.
An equipment loan may also have a simplified process, compared to an unsecured loan. Because the equipment is used as collateral to reduce bank risk, traditional loan criteria (such as time in business, credit history and revenue) are less important. The bank needs proof the business can make loan payments, of course, but it may not require the same level of documentation about the business that another type of loan demands. The value of the equipment secures the financing.
Does it matter what type of loan I get?
Every type of loan carries its own unique terms and conditions, depending on what the bank is comfortable offering, risk of default, how hungry they are to make the loan or start a new relationship with a particular company, and what their current loan portfolio looks like.
One bank’s terms may not be the same as another’s for the same type of loan, and terms for similar loans within the very same bank may vary based on the individual business. There’s tremendous variety and flexibility in financing, so it’s important to look beyond the monthly payment amount and length of the loan.
Despite the differences, there are a few tried-and-true features of most equipment loans that separate them from general business loans.
Payments are typically matched to the expected lifespan of the equipment. This is important to ensure a borrower doesn’t pay for equipment long after it’s gone. If restaurant ovens last about seven years before needing replacement, for example, a banker won’t do a fifteen-year equipment loan. If that happens, the borrower will eventually need to finance their replacement while still paying off the original loan.
It also might not make sense to purchase those ovens using a line of credit that must be paid off in just one year. Not only will the payments be extremely high to ensure timely payoff, consuming more cash each month than is necessary – but it ties up the line of credit, leaving the business vulnerable if it encounters cash flow issues before the line of credit has been paid down.
Limitations around the purchase it funds are another common feature of an equipment loan. The borrower is limited to fulfilling a specific purchase order covered in the loan agreement. The loan amount cannot exceed the equipment purchase for operational costs or inventory, or be used to purchase equipment different from what the bank agreed upon. The purchase is closely monitored as a collateral asset.
Borrowing money for a business isn’t just about funding; it’s about the right mix of financial options that make the most of every asset the business has to ensure success and long-term health.
What do I need before applying for an equipment loan?
If you already do business with a commercial bank for a business checking account or credit card, scheduling a consultation is an excellent first step. It gives you a chance to discover various lending options and the impact each will have on cash flow, and discuss the application process. The pre-existing relationship may qualify you for discounts or more attractive terms on the new loan.
Should you consider an online loan, or lenders other than banks? It depends, based on creditworthiness. Banks typically offer the lowest interest rates and more attractive terms than a nontraditional lender if the business has a credit history, positive cash flow and has been in existence for more than two years. If the business is new, has a past bankruptcy or minimal credit history and can’t offer a substantial down payment as equity for the loan, a bank might not be the best option.
No matter what type of lender you are considering, it’s important to have some sort a credit history in the name of the business before applying. Business checking and credit card accounts, past loans and/or a merchant credit card processing account can help the lender assess payment behavior and creditworthiness. A track record of paying on time is important for the business, too. Normal credit standards will apply and as always, better credit ensures better terms.
Depending on creditworthiness of the business and other factors, the lender may require a personal guarantee to approve the loan. Cleaning up personal credit history and ensuring the best possible credit score before applying is never a bad idea.
Even though documentation requirements can sometimes be lighter for an equipment loan, the borrower will need current profit and loss statements for the business. This helps borrower and lender see beyond cash flow to the true profit margin of the business. Documentation of other financial obligations should also be assembled to support the financial statements.
For any less established business, a complete, updated business plan can support its loan request. Showcasing leadership and industry expertise, realistic goals and future plans reassure lenders, even if it’s not required. Who knows, maybe it will be the tipping point for approval? After all, anything that reduces lender risk works in your favor.
If you have questions about an equipment loan, Horizon Community Bank is here to help you. Contact us today for a no-obligation consultation!