When purchasing equipment, you have to decide whether a shorter loan with a higher interest rate or a longer loan with a lower interest rate is the best choice for your business. The answer greatly depends on whether your cash can be deployed elsewhere at a return above the rate spread.
“Ask one question first: can my business earn more on a dollar than this loan costs me in interest? For most landscapers the answer is yes, often by a wide margin,” says Andrew Trower, CPA and founder of Andrew Trower & Associates. “When that is true, the goal is to keep as much of your cash in the business as possible.”
Short- Versus Long-Term Loans
Trower argues that by this logic, as long as your debt service coverage ratio stays in a healthy range, it is better to opt for the longer-term loan.
“A longer term means smaller payments, which leaves more cash free to redeploy into the business where it earns a higher return,” Trower says. “On top of that, the interest is tax-deductible, which lowers the real cost of borrowing.”
While long-term loans do have a higher rate, it can also protect your business during slow seasons.
“Smaller companies often end up on the longer term out of necessity, because they need the lower payment to protect cash flow,” Trower says. “The good news is that this usually lines up with what I would recommend anyway. Keeping payments low and cash free is exactly the right instinct for a growing company, so the constraint and the strategy point in the same direction.”
Meanwhile, short-term loans with lower interest rates are a good fit when you have no higher-return use for the cash, when you are near the end of a growth phase and want to clean up the balance sheet, or when the asset has a short life.
“In those cases, paying less total interest and owning the asset free and clear sooner is the better outcome,” Trower says.
Going all in on either loan type isn’t the best idea, though, as long-term loans can leave you carrying debt on assets longer than you should, and more total interest if the cash was not actually redeployed well. Only using short-term loans can lead to large payments that choke your cash flow, especially in the off-season.
Instead, it’s best to opt for a mix of these loan types, but there is no magic percentage to aim for.
“The right mix falls out of applying the framework to each piece of equipment, its useful life, and where your cash is best deployed at the time,” Trower says. “Let each decision stand on its own and the overall mix will take care of itself.”
Factors to Consider
Some of the factors to weigh when selecting the right loan type are where your cash will earn the most, the seasonality of the business and the useful life of the equipment.
In cases where cash can be put to work well above the loan rate, the longer-term loan wins. However, if you value being debt-free quickly, the shorter-term loan can make sense. Trower says you also need to consider your cash flow and how predictable your season is.
“Longer terms with smaller payments are easier to carry through the slow months, which is another reason the longer term often fits this industry well,” Trower says. “Whatever you choose, make sure you can cover the payment in your weakest months, not just your best ones.”
You should also weigh the useful life of the equipment. Items that wear out quickly, like handheld equipment, suit shorter terms because they do not last long. Big-ticket, long-lived assets like trucks and larger machines fit longer terms.
“You never want to still be making payments on a mower or truck that has worn out and stopped earning, because then you are financing a dead asset and its replacement at the same time,” Trower says. “So take the longest term available, with the simple limit that the loan should be paid off by the time the equipment is done earning. For most landscape equipment, lenders won’t offer a term beyond its useful life anyway, so the longest available term and the right term are usually the same loan.”
The final aspect to take into account is how each loan type will be impacted by an economic downturn.
“Short-term loans carry the bigger downturn risk, because the high payments keep coming even when revenue drops,” Trower says. “Longer terms with smaller payments give you more breathing room when times get tight. That cushion is a real part of why I lean toward the longer term, especially in a seasonal, cyclical business.”
