What is an equipment loan and how does it work?

Monty Rakusen/Getty Images; Illustration by Austin Courregé/Bankrate

So your company needs to buy something big. Whether that’s a new copier, restaurant equipment or even a semi truck, an equipment loan might be just what you need.

Offered by banks and online lenders, the best equipment financing can help business owners who need new equipment to start or grow a business or repair or upgrade old equipment to remain competitive.

While this loan can be easier to get approval for, it has some drawbacks worth considering.

What is an equipment loan?

An equipment loan is financing you take out to buy a specific piece of business equipment.

And in this case, equipment can be pretty broad. Companies take out equipment loans to finance the purchase of:

• Computers
• Office furniture
• Vehicles for commercial use
• Machinery
• Commercial kitchen equipment
• HVAC units
• Phone systems
• Printers and copiers
• Medical equipment
• Industrial equipment

In other words, if your company needs to make a big purchase of a tangible asset, an equipment loan can help you break it into manageable payments that you make over time.

How does equipment financing work?

Equipment financing works by using the equipment you’re buying to secure the loan. The equipment becomes collateral, meaning the lender can seize the asset if you fail to repay what you borrow. You may also have to provide a personal guarantee, which requires you to be personally responsible for the loan if your business can’t pay the loan back. This puts your personal assets at risk.

Equipment financing usually comes with a fixed interest rate and a requirement that you make periodic payments to repay the loan. Usually, the loan term falls somewhere between three to 10 years.

Many equipment loan options require a down payment, anywhere from 10 percent to 20 percent, depending on the lender.  The more money you can offer as a down payment, the more favorable the interest rates tend to be.

Equipment loan eligibility requirements

As with any financing, banks, credit unions and equipment financing companies vet you before offering you the loan. That means they will look at several factors, including:

• Your business credit score
• Your personal credit score
• How long you’ve been in business (you usually need to have existed for at least a year to get approved)
• Your business’s profit and loss statement
• The value of the equipment you want to purchase

It’s possible to find lenders willing to work with business owners with bad credit and limited time in business. But the more favorable those factors look to the lender, the better the interest rate you’ll score on your equipment loan.

That interest isn’t the only potential cost to evaluate. Some equipment financing comes with loan fees like origination fees, late fees, or prepayment penalties, so be sure to read the fine print to know what you’ll potentially pay.

Equipment loan vs. equipment leasing

You can compare this to buying a car. With an auto loan, you pay more monthly, but you own the car once you pay off what you borrowed. When you lease, you essentially rent the vehicle, which has several advantages.

Equipment leasing typically doesn’t require a down payment, making it a better option for business owners who can’t afford to tie up funds to purchase equipment. Another advantage to leasing is that it can protect you from depreciation or obsolescence. If you’re buying something that won’t be worth much — or even functioning or relevant — by the time your loan term ends, owning the asset doesn’t go very far. With little-to-no resale value, leasing it might make more sense for your business.

Pros and cons of equipment loans

If you’re still trying to decide between an equipment loan and a lease, knowing the pros and cons of equipment financing can help. Here are some of the upsides and drawbacks of an equipment loan to consider:

Where to get an equipment loan

If those pros outweigh the cons, here’s a look at where to find business equipment loans.

• Traditional banks and credit unions. Many of the same financial institutions that offer other types of small business loans offer equipment financing. You’ll generally need to meet more stringent criteria to qualify, but an equipment loan from a bank or credit union may come with a lower interest rate and better repayment terms than one from an online or equipment-focused lender.
• Online lenders. Online or fintech lenders typically offer streamlined applications, which can mean faster and more accessible funding. They can be a good option for startups and business owners who don’t have good or excellent credit.
• SBA lenders. These equipment loans are backed by the Small Business Administration (SBA). Like bank and credit union equipment financing options, these generally have stricter underwriting requirements but favorable rates.
• Equipment financing companies. Some companies specifically offer loans to buy business equipment. Like online lenders, getting approved for loans from equipment financing companies can be easier and faster, but both come with high rates and fees.
• Equipment manufacturers. Sometimes, the company that makes the equipment you want to buy will offer a financing plan. While this may sound convenient, this option usually comes with higher interest rates than other lending sources.

Alternatives to equipment loans

If, after learning what equipment financing is, you decide it’s not for you, there are other ways to pay for your new asset. Here are some alternatives to equipment loans:

• Business credit cards: If you can get a good introductory rate on a business credit card, you may be able to avoid interest payments for up to a year.
• Equipment leasing: You may want to consider leasing your equipment. While this doesn’t build equity in your company, it allows you to have access to the equipment you need until you can afford a loan.
• Term loans: Business term loans can be used for business assets and a wider variety of business-related expenses.
• Lines of credit: Business lines of credit are revolving accounts. Like a credit card, you can spend up to a certain amount and pay interest on the money you’ve borrowed.

Bottom line

An equipment loan can enable your business to buy even expensive tangible assets that will help it thrive. Since the equipment acts as collateral, this loan can be an accessible option for startups and bad credit borrowers. But as with any form of financing, it comes at a cost: interest and possibly even fees.

To make sure your business doesn’t overpay, evaluate options from at least a few lenders before you sign on the dotted line.

Frequently asked questions

• What are typical terms for equipment loans?

  Usually, these loans must be repaid between three to 10 years. The interest rate varies depending on your business’s unique qualifying factors, like its time in business and its credit score.

• What credit score is needed for an equipment loan?

  Generally, you’ll need a personal credit score of 575 or more. That said, credit score is just one factor lenders consider. A bigger down payment, more time in business, other collateral and solid annual revenue at your company can all help to make up for poor credit.

• Is it hard to get a loan for equipment?

  Generally, getting an equipment loan is easier than other types of small business loans. This is thanks, in part, to the fact that the equipment serves as its own collateral for the loan.