Every businesses situation is different; therefore, there is no single correct answer to this question. However, there are some basic principles that customers need to understand when deciding whether to pay out the contracts early or faster:
- Equity in equipment ties up cash – There are many other options for using capital for a business that provides a positive “return on investment”. If you choose to pay off your loan quickly and decide you need that capital in the future, it is very difficult (or expensive) to release that capital for other purposes.
- Most fixed-term Equipment finance contracts charge penalties for early termination. Suppose you pay off an equipment finance contract early. In that case, most financiers will retain a proportion of the future interest as a penalty for paying out early, therefore significantly negating the advantage of paying out early.
- Interest expense is tax-deductible – In most circumstances, the interest (or a proportion of it) is tax-deductible. By paying out your contract early, you will reduce your tax-deductible expenses.
One of the biggest mistakes is that the business goes through a good financial period and feel the need to “clear out” some debt. Then, there is a downturn in the market, or there is some negative impact on the business, and they don’t have the cash surplus to withstand the downturn.
Many businesses have the cash to pay for equipment. Still, they choose to finance the equipment as they understand the importance of conserving cash flow and “leverage” the business financially.
There is more to financing equipment than being quoted a monthly repayment. A good finance company or broker should provide businesses with a tailored finance solution that meets various needs.
Many businesses often make a decision based on the interest rate or the monthly repayment. While this is an important factor, the “right” finance solution looks at the type of equipment, how it is used, the future of the business, banks credit restrictions, the strength of the customer finance application, and other factors.
The art in tailoring a finance contract is to understand a customer’s short and long term needs and find a balanced solution that considers all the factors that can impact the effectiveness of the finance contract.
Entering into a finance contract that is not tailored to your needs can result in cash flow pressure or incur opportunity costs of a poorly structured contract.
For Example: A successful sole trader excavator operator wants to upgrade his excavator and he has good cash in the bank and earns a good income. He is thinking of putting in a large deposit and paying it off quickly (i.e. over three years).
This may sound like a good idea on the surface, but it may not meet his longer-term needs when we dig deeper into his situation.
After a brief conversation, we find out he does not own a house and is planning on buying something in the next 18 months, and the contract he is currently working on is due to finish at the end of the year.
Therefore, his decision to use his cash as a deposit reduces his funds that he could use to buy his house. Also, the short term on his equipment finance contract creates a high repayment, therefore reducing his capacity to borrow on his future home loan application. In addition to this, his contract finishes shortly may create some uncertainty around his cash flow position in the future.
The client ended up not putting in any deposit to conserve his cash and financed over a longer term to keep his payments to a minimum.