Jim Peach, CLFP
We all get excited when we find the perfect “thing” to buy. Whether it is the latest tech gadget, fun gift or favorite snack, sometimes we lose ourselves in the adventure and let our emotions take over, regardless of the size (or investment) of the purchase.
This same sense of euphoria can also occur when purchasing a new piece of equipment. Maybe you have been searching for the “right” used vehicle for months or suddenly find your dream machine at auction—and now you are ready to buy using financing—and you’re pumped!
Before you sign on the dotted line, though, do your future self a favor by truly understanding the many factors that impact the cost of financing your equipment … beyond the rate. One of the biggest components to grasp is the early payoff structure.
What Questions Should I Ask?
There are some questions you should ask prior to finalizing any financing agreement, especially as it relates to an early payoff. We will walk through some of these questions—including which are more effective than others—to best prepare your small business for entering into a contract.
The Semantics of “Early Payoff”
If a financing contract is set for a 60-month term, sometimes customers inquire about paying it off early. Attempting to better understand the terms of the contract upfront, customers often ask the question: “Is there a pre-payment penalty?”While this might seem savvy on the surface, the answer could be misleading.
The answer to this question could be “yes” or “no” depending on the terms of the contract; however, answering “no” does not necessarily mean you’ll save money. Here’s why: many equipment finance agreements stipulate that the customer is responsible for the full payoff (including interest) regardless of the payoff date, so there is never really any opportunity to save money.
Instead, the question we encourage you to ask is: “Will I save money if I pay off early?”By posing this question, you’ll get a cut-and-dry “yes” or “no” answer. It is essential to understand how this question appears in your equipment finance contract, so there are no surprises a few months or years down the road when you attempt to pay off your purchase.
Many might ask, “Why wouldn’t businesses want their money paid back sooner than the predetermined schedule?”By including interest on your piece of equipment, that is how financial institutions make their money. By paying your loan off one year early, they are losing 12 months of interest. That is usually why a pre-payment penalty is in place so the lender can recoup all the interest that was owed when signing your contract.
Other Forward-Thinking Questions to Consider
- “Does the loan amortize?”: With an amortized loan the majority of your payments go towards the interest on the loan. As time passes, the payments are applied to the principal. By looking at your amortization schedule, you will be able to see how much of your payments are going towards principal and interest. That being said, being able to pay down your loan early may or may not save your business money in the long run.
- “Will prepaying affect my taxes?”: When making an equipment purchase for your business, you can declare the interest on your loan as a deductible on your businesses tax returns. By paying off your loan early, avoiding future interest, it may result in losing a portion of your deductible. Do not hesitate to not only ask your finance provider but also your accountant if this could become a factor in your pre-payment decision.
- “Are there additional payments due at the end of the term?”: If you do decide to pay a loan off early, it is good to know whether you will incur any additional fees or extra payments at the end of the term, to close the loan. It is best to find out before finalizing the agreement to manage your expectations down the road.
- “Are there conditions that must be met to get an early payoff?”: The answer to this question has to do with how the contract is written. Some contracts have conditions that must be met for an early payoff to occur. Often contracts require that you have never made a late payment, others are contingent upon a credit review or only allow early payoffs if you are financing your next piece of equipment with the company. Be sure to read the fine print and ask questions when it comes to these “contingencies.”
- “How is the payoff calculated?” :When asking this question of the lender, the answer should be very straightforward; if it is not, that is a red flag.
Understand Your Contract Structure
Before committing to any financing agreement, make sure you understand the contract structure. As mentioned earlier, many factors impact the cost of financing your equipment; if you do not understand something, ask! Choosing the right finance partner could have a significant impact on your business growth. We encourage you to shop around to understand what different institutions can offer when it comes to understanding early payoff.