When a firm procures a loan to finance new equipment, it may use the equipment itself as collateral for an intermediate-term loan. These loans are called equipment financing loans. Equipment financing loans are commonly made for readily marketable equipment. These loans are normally made for somewhat less than the market value of the equipment, and the difference provides a margin of safety for the lender. This difference may range between 20 and 30 percent for readily marketable and mobile equipment, such as trucks or cars. The amortization schedule for an equipment financing loan is usually tied closely to the asset’s economic life.
There are several potential sources of equipment financing, including commercial banks, sales finance companies, equipment sellers, insurance companies, and pension funds. Commercial banks are often the least expensive source of such financing —especially when compared with sales finance companies. The equipment seller may provide financing either directly or through a captive finance subsidiary (that is, the seller’s own financing subsidiary).
Although at first glance, an equipment seller may appear to charge a very modest interest rate, it often is difficult to make a meaningful comparison between the rates charged by a supplier and other financing sources, such as commercial banks. The reason is because the selling firm might price the equipment in such a way as to conceal part of the cost of carrying its credit customers; that is, noncash customers may pay relatively higher prices than cash customers.
There are two primary security instruments used in connection with equipment financing loans; the conditional sales contract and the chattel mortgage. Each of these is discussed in the following subsections.
Conditional Sales Contract
When a conditional sales contract (sometimes called a purchase money mortgage) is used in an equipment financing transaction, the seller retains title until the buyer has made all payments required by the financing contract. Conditional sales contracts are used almost exclusively by equipment sellers.At the time of purchase, the buyer normally makes a down payment to the seller and issues a promissory note for the balance of the purchase price.
The buyer then agrees to make a series of periodic payments (usually monthly or quarterly) of principal and interest to the seller until the note has been paid off. When the last payment has been made, the title to the equipment passes to the buyer. In the case of default, the seller may repossess the asset.
A chattel mortgage is a lien on property other than real estate. Chattel mortgages are most common when a commercial bank or sales finance company makes a direct equipment financing loan. It involves the placement of a lien against the property by the lender.
Notification of the lien is filed with a public office in the state where the equipment is located. Given a valid lien, the lender may repossess the equipment and resell it if the borrower defaults on the loan payment.
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