3 mistakes to avoid when leasing equipment

All lending in Canada is based on the prime rate, which is the annual interest rate that major banks and financial institutions use to set interest rates for variable loans and lines of credit.

Any business that borrows money from the bank, regardless of whether it is a term loan, operating line, or line of credit, will have its borrowing rate based on the prime rate, which currently sits at approximately 4 per cent.

Depending on the amount borrowed and the financial strength of the borrower, the actual cost will be anywhere between 0.5 and 3 per cent above the prime rate. If an alternative lender is arranging financing for equipment and has only the equipment itself as collateral for the transaction, the lender will charge something slightly higher. With that being said, when the borrower’s credit is strong, the actual cost could be a matter of only a single percentage point above prime.

Understanding this background makes it less likely that mistakes are made during financing.

Limit leasing mistakes

Generally speaking, borrowers make three mistakes when they look into securing a lease. They are:

1. Comparing equipment leases with car leases.
A typical person’s experience with leasing usually comes in the form of arranging financing for their car. What happens next is that they look at how that transaction was handled and the rate charged, and try to compare it to arranging a lease for machinery to be used on their shop floor. These, however, are two totally different types of transactions.

First, when a customer leases a car, the lease structure is much different because the lender normally will have large residual at the end of the transaction, in many cases up to 50 per cent, which is guaranteed by the dealer. This means that the customer literally has the option to either purchase the car or toss the keys back.

The dealer is more than happy to take the car back and then resell it because it makes a better profit from the sale of the used car than if it were new.

The structure of a typical equipment lease is either 10 per cent at the end of the term or a very nominal amount (even $1), and the borrower automatically takes ownership.

Second, the car lender has the ability to offer very cheap lease rates, usually between 0 and 2 per cent, because the rate is subsidized by the manufacturer.

This can be a common strategy for equipment leases as well; some OEMs offer very cheap rates by using the same method.

I always tell my customers that they are much better off negotiating the best price for the equipment and keeping the financing as a separate entity. When we do the math, we find that they save more money in the long run by taking a substantial upfront discount (all equipment funders pay the seller in full upon delivery) and arrange the lease at true market rates.

2. Selecting low-cost equipment because of a weak credit profile.
When evaluating the application for an equipment lease, the first thing lenders look at is the asset being financed. When it comes to machine tools, anyone with industry knowledge knows a good, brand-name machine tool has excellent resale value.

Because a lender’s first concern is exit strategy in the event a deal goes bad, it wants to know that the asset can be resold with relative ease and recover a significant portion of the outstanding balance.

Next is the size of the transaction and whether it fits the equity box of the applicant. Specifically, lenders look at a borrower’s total net worth.

It is important to keep in mind that a new piece of machinery will start depreciating the moment it is installed in a manufacturing facility. If the buyer’s credit isn’t strong, the deal comes back to the asset that is being financed, because it’s the collateral for the lease.

When a buyer’s credit is less than stellar, it often tries to find an inexpensive machine, figuring this is the path of least resistance to getting a lender’s approval. However, the reality is that lenders prefer to finance a better asset, because it holds a higher resale value and can be resold easily if the deal goes bad and the machine is repossessed.

So how can you finance a quality machine when your credit isn’t good? The answer is simple: Provide a good deposit.

3. Not providing a deposit.
In most cases in which a lease transaction does not fit a borrower’s credit profile, the best way to put a lender at ease and facilitate an approval is by offering a deposit.

Because equipment lenders familiar with manufacturing prefer to finance quality equipment, offering a substantial deposit allows them to mitigate their risk even further and assist them in finding a way to approve a transaction that would normally be declined.

During the first year the transaction is at its highest risk because the asset depreciates by its largest percentage and very few payments have been collected. From the lender’s perspective, it is very meaningful, and in certain cases necessary, to get a deposit. Essentially the deposit counteracts the first year of depreciation.

There are many lenders out there, even when a borrower’s credit is strong, that want a deposit for the first deal of a new relationship because it provides a level of comfort that cannot be duplicated.

Ken Hurwitz is senior account manager, Blue Chip Leasing Corp., 416-614-5878, www.bluechipleasing.com.