Many small business owners may not know that there are differences between an Equipment Finance Agreement and a simple interest loan.
From an end-user’s point of view, the two can look identical. However, an Equipment Finance Agreement (EFA) is usually looked at as a link between a lease and a loan.
Tatum Noreen, who works as a client relations lead at Stearns Bank, has noticed that her customers can be confused at times when trying to compare an EFA and a standard simple interest loan.
“One of the biggest things they have to learn is that an EFA is different than what they’re typically familiar with,” Noreen said.
► The two biggest differences between an EFA and a simple interest or consumer loan are no stated rates or breakdowns between principal and interest in EFA contracts
► An initial down payment isn’t typically required with an EFA, unlike a simple interest loan
The two biggest differences between an EFA and a simple interest or consumer are 1.) EFAs have no stated interest rates, and 2.) there is no breakdown between principal and interest in EFA contracts.
The finance charges are calculated into a stream of fixed contractual payments over the course of the chosen term. The customer is responsible for the gross contract amount, which is the sum of the contractual payments.
For example, in a 60-month term, the customer is responsible for all 60 payments. However, the customer can pay those 60 payments off at any time without a penalty. However, unlike a principal and interest loan, early payments on an EFA do not reduce the amount of finance charges owed. If a customer is more conscious of the total amount of finance charges, lenders like Stearns Bank can always shorten the term.
The Benefits of an EFA
According to the Equipment Leasing and Finance Association, more than 80 percent of all United States companies utilize some form of equipment financing.
Small business owners choose to finance rather than outright purchase equipment for many reasons, including:
- Preserving cash flow – Financing saves small business owners money up front so they don’t have to dip into reserves that they could use for other needs
- Convenience and speed – When using an EFA, the deal can be completed in a shorter amount of time than a simple interest loan
- 100 percent financing – An initial down payment isn’t typically required with an EFA while it is more likely required with a simple interest loan. EFAs are able to include shipping, training and installations whereas consumers may have to pay those fees upfront in a simple interest loan.
- Tax advantages – Financing helps reduce tax liability and can be used to qualify as an operating lease for tax reporting purposes using Section 179. Under the new Tax Cuts and Jobs Act, the annual deduction limit was raised to $1 million. The highest annual investment limit for qualifying equipment purchases was set at $2.5 million.
- Managing Equipment’s Life Cycle – Financing equipment to make regular upgrades to a small business reduces the risk of older equipment breaking down
The Benefits Of Working With A Lender On EFAs
Noreen recently completed a transaction for a small business owner from Clearlake Oaks, California, who was buying a truck and selling another piece of equipment in the next six to 12 months.
With a customized step payment option, Noreen negotiated a two-year term on the piece of equipment with smaller payment amounts up front.
After one year, the payments jumped up a little bit, but since the small business owner is planning to sell the other piece of equipment, they will be able to pay off the contract with that additional money coming from the sale. This allows the customer to have payments closer to that of a longer term, but pay the finance charges of a shorter term since they’re looking to pay it off earlier.
“Our financing team always talks with each other about how we can come up with the best solutions for our customers,” Noreen said. “There are always ways to help them customize their terms based on their needs.”
It is always recommended to consult a tax advisor on the benefits of equipment ownership through an EFA versus a normal lease payment agreement before deciding which route to choose.