I say that because in this series of “how do lenders arrive at interest rates?”, I’ve talked about different factors that affect the rate you pay.

But where does that rate originate? It doesn’t start at zero (after all, money is never free).  

In general terms, most lenders will utilize existing benchmark rates as a starting point. Then those benchmark rates get adjusted upwards using all of the factors I’ve discussed in previous posts (e.g., equipment type, collateral, credit scores, market conditions, etc.) In other words, a starting point using a benchmark rate is established, then your loan parameters go down a conveyor belt (so to say) comprised of all the other factors I’ve posted about, each one possibly affecting the final rate you pay. 

So what are these benchmark rates? Let’s take a quick look:

The Federal Funds Rate: This is the most common benchmark rate, and many lenders use this as a starting point for short (24-60 month) loans. This is the rate banks charge each other for overnight lending (which is assumed to have the least amount of risk). The Federal Funds rate is the one most people know about, because that’s generally the rate that’s talked about when the news says “The Federal Reserve raised/lowered rates 25 basis points”.

ICE Swap Rate: This is the rate where banks will swap interest rate payments. It’s a useful tool to help banks manage risk and volatility. For example, Bank A may have excessive variable rate loans, while Bank B has an abundance of fixed rate. Both would be better off with a more balanced spread, so they swap interest payments on some of them. The Ice Swap Rate is the premium they pay for this swap. There are different ICE Swap rates for different time periods, and for consumer lending purposes, the longer ICE Swap terms are typically used as a benchmark for longer-term loans.  

SOFR (Secured Overnight Financing Rate): This one is increasingly used for variable-rate loans. This is the overnight lending rate using US Treasuries as collateral. It is calculated daily by the Federal Reserve, so it’s always current and relevant to the economy, and since it utilizes treasuries, it’s considered quite stable. When rates are going to change in a loan, SOFR makes for a good starting point.

Treasury Yields: Long-term loans can be tricky. Since predicting the future is hard, we can’t know what economic conditions will be in a decade or more. But our best guess can come from what the US Government is comfortable with on treasuries.  So, Treasury Yields may be used as a baseline for longer-term loans.  

There are lenders that may use other benchmarks, but in general terms, these four should cover most loans and terms. 

Now, it’s very important to remember that these are only baseline rates.  They will always go up based on risk. And while most of us like to think we personally are good credit risks, the truth is, risk-free lending is impossible. So the baseline rate is always going to go through the gauntlet I’ve previously written about. Even lending to billionaires carries some risk. Trust me, Bill Gates himself would pay higher than the federal funds rate if he borrowed money.

I hope this post gives you at least a basic insight as to where rates begin. If you’re interested in seeing some of these rates, here are a few links:

Federal Funds and SOFR

ICE swap rate (requires a license subscription)

Treasury rates are available at the treasury website

I say “finally” because to many people, the credit score is the be-all, end-all of borrowing. And it is true that credit scores and related risk factors are important, but not always in the way people think.   

I look at credit scores and related two ways: in one way, they can be a gatekeeper. Lower than, say, 650-700, and many higher-quality lenders are going to turn potential borrowers away without considering anything else. This is why many people consider them super important (and they are).

But in terms of affecting the rate, we have to already assume a borrower has met this minimum threshold. So from that point, all of the other factors I’ve already discussed have approximately equal or even greater impact on the rate.

Here’s why: while your credit score is impactful, not all credit scores are created equal. Two different credit reports each with a 700 score could have very different paths to get there. Maybe one has a thick file with 20 years’ worth of history and the other has a thin three. The 20 years speaks a lot louder. 

But it’s not just FICO scores. There are several other scoring systems like D&B’s PAYDEX, SBRi, Experian’s Intelliscore Plus, Equifax’s Payment Index, PayNet MasterScore v2, and even FICO SBSS for small businesses. Many lenders will also use public records (suits, liens, judgments) in not only making decisions, but helping to determine a rate. 

Any or all of the preceding reports and scores are utilized by most commercial lenders on most loans. For Crest Capital, we utilize many of these in our application-only loan process (deals $150k and under).  

But besides scores, what else could affect your rate? There are a few other overall factors that most lenders will look at with almost any type of loan:

• Industry Risk – Certain industries are riskier than others. For example, the restaurant industry is extremely volatile, with new openings experiencing an 80% five-year failure rate. However, over that same five-year period, the self-storage industry has a low 8% failure rate. So, all else being equal, who would you rather write a five-year loan for? And who should get a lower rate? No brainer, right? All industries have a risk factor, with the more stable ones typically getting better rates. In fact, many lenders won’t even engage with riskier industries.

• Economic forecasts – There’s always a bit of a crystal ball with lending. How is the economic forecast? Nationally? Industry-wise? Locally? These are all going to matter.

Hopefully, this blog has given you a good insight into how credit scores and other factors can affect your rate. If you want to learn a little more about Crest’s process and what we look for, check out our Equipment Financing Credit Requirements page.

Risk is one of the largest factors affecting the rates you pay. In fact, nearly all lending rates begin at whatever the Federal Funds Rate is, and are then adjusted upwards based on risk and lender overhead.

But risk is the big one, and it’s also quite variable, with almost all borrower risk profiles being unique, and quite multifaceted.  Of course, on the surface, you would think the borrower’s credit score essentially constitutes the lender’s risk. But it goes a lot further than that.

Indeed, I’m looking at my list of topics for this series:

1.  Common misconceptions about rates. (already posted)
2. The relationship between risk and the rate. (we are here)
3. How loan type and intended use affects rates.
4. Collateral and rates.
5. Internal cost of funds and rates (aka, “how much does money cost?”).
6. Defaults and rates.
7. Credit scores and other risk profiles affecting rates.
8. Benchmark rates and market conditions.

And I can see that numbers 3,4,6,7 are all directly related to risk. #8 also has a little risk in there. #5 doesn’t (and I’ll likely be including lender overhead in that one too).

So yes, risk is a big factor in rates. The more risk (taking into account all of these factors), the higher the rate. That’s the quick answer.

Now someone may ask “well, why is that? Why does the rate go up with more risk? Why does more risk to the lender cost borrowers more?”

Well, riskier loans have a higher chance to default, right? And in the aggregate, this must be taken into account. A lender cannot be profitable otherwise. 

Without getting too deep into the math, lenders use an actuarial approach similar to insurance companies. Just like insurers predict fire claims in certain demographics to set rates, lenders analyze numbers to predict loan defaults based on risk profiles. The thing is, the models cannot predict individual outcomes, so borrowers are categorized by credit score, collateral, loan type, etc.

Now I must be emphatic – loans going bad is a serious topic, as the consequences are devastatingly costly to a lender. Not only do they not get paid back the money they lent, but recouping any funds is difficult and drawn out.

For example, first think about the lender repossessing the item and selling it. All well and good, but this costs money – someone must physically retrieve the item (not always a pleasant transaction), inspect it, repair it, clean it, list it, and sell it. Nobody does these things for free. Plus, the item will certainly have significant depreciation. So repossession falls into the “better than nothing but certainly not optimal” bucket. 

In addition, defaults do not just disappear from a lender’s books – the money owed must be made back from somewhere. Can a lender “write off” some losses? Yea, sort of. But it’s a) complicated and time-consuming, and b) only a fraction of what was truly lost. 

Listen, defaults are always very unprofitable. And the money needs to be made up from other borrowers in the form of rates, which is exactly what we are talking about here. When I talk about risk, I am really talking about expected defaults, and that makes rates go up.

In the end, the rate on any given loan needs to be profitable enough to offset the expected loss for whatever the total risk profile is. Plus, lenders must also account that riskier loans require more regulatory rules (i.e., cash on hand, which we’ll discuss in internal costs). And that costs money as well. 

Like I said, the actual nuts and bolts of the “why” boil down to a complex set of math formulas that take all kinds of factors into account. But for purposes of discussion in this series, just understand that increased risk = increased rate.   

If you thought the bank saying “yes” when they gave you the loan was the end of them looking at your company’s finances, think again – it’s not. Written into virtually every bank loan contract is a clause that gives the bank the right to make a borrowing company “requalify” for the loan annually. And if the bank doesn’t like what it sees, they reserve the right to call in the entire loan immediately.

That’s scary. Especially since the last two clauses we discussed – the blanket lien and the compensating balance – means they can collect immediately. They can fully take that compensating balance they insisted on, and then they can seize any of your assets to satisfy the rest. That could cripple many companies. 

The really odd part is you need not default on the loan for this to happen. You could be making all your payments on time, but if your overall financial picture degrades, the bank won’t care that they are still getting paid on time. They will instead say “you don’t qualify for this loan anymore”.

The thing is, a temporary drop in any company’s finances can happen. For example, maybe you lost your largest customer, and while your sales team is working hard to replace that revenue, your numbers are temporarily down. Or a bridge on your main road fails, resulting in an unavoidable-but-unfavorable-for-you detour. And it’s going to take six months for much of your retail traffic to return. Or a hundred other reasons revenue and profits temporarily drop. It happens – that’s business.

So imagine something “temporarily bad” like the above happens, but then the bank makes it 100x worse by calling in your loan(s). Talk about pouring when raining… 

This is why yearly requalification is such a scary bank clause. It sits there innocently in the fine print, but when it does emerge, it’s always at the absolute worse time.  

So what can you do about these bank restrictions? We’ll talk about that next.

A compensating balance is when a bank requires a business to keep a certain balance amount in an account with them. This balance amount is typically 80% of the equipment loan.

The key factor is this is it’s a required minimum balance, meaning the balance cannot fall under that 80% amount. In other words, it’s money that is technically yours, but it’s kind of not, because it’s locked up and you can’t use it. 

In addition, it’s very likely this money will need to be in a typical business checking / business account that’s paying next to nothing. No bank is going to give you the special “36-month CD rate” on your compensating balance.

So here’s what you end up with: a big chunk of your money NOT working for you, that you cannot use either. Instead, it quietly sits there, just in case you decide to default.

This brings up a very valid point. If you can’t use the money in the account, whose money did you actually borrow? If you answered “it’s like I borrowed my own money” you’d be right. That’s exactly what it is, in fact.

Many companies don’t even realize this happens, because they often use their own bank for equipment financing. So they have money in the bank anyway. Even if they are aware of the compensating balance the loan officer may say “it’s no big deal – you already have your money with us anyway”. 

But that’s not the point. The point is it’s money you cannot use. And honestly, money that you cannot use but also isn’t growing is pretty useless, and not a good business practice.

If you value financial flexibility and spending your money the way you wish, look for a lender who does not use compensating balances, like Crest Capital. We don’t care what you do with your money. After all, it’s yours, and you can spend it any way you like. 

THAT’S Freedom!  

First let’s talk about liens in general. In business/lending, a lien is when a lender claims the right to property belonging to the borrower until the debt owed by that borrower is discharged.

The mainstream talk on liens is usually related to vehicles. You don’t pay your car loan, and your car gets repossessed. And you cannot sell your car until the loan is paid off, and the lender discharges the lien. And of course, you should never, ever buy a car with a lien on it.

But liens can extend to any piece of tangible equipment. Very often, if you borrow money to buy a piece of equipment, the piece of equipment itself will have a lien on it. And that’s expected and fair.

But what a blanket lien does is it blankets your entire company with a lien. This means everything your business owns has a lien on it. So if you borrow money from the bank to buy, say, a new delivery truck, they will put a blanket lien on your company so everything your company owns will have a lien on it. Not only can you not sell that new delivery truck, you can’t sell the old, long-paid-off one either. You also can’t sell any machinery, tools, or anything else. 

Technically, you can’t even give anything away. Maybe you want to give your old office computer to your nephew… better check with the bank first. Because legally, they have the rights to that computer. I’m not saying they would deny that, but that’s not the point: legally, they can. 

Blanket liens are pretty cut and dried, and very enforceable. They also smother your company because you cannot sell anything without the bank’s permission (and no astute buyer will buy anything with a blanket lien in place). This severely restricts your finances and your flexibility.

It’s always my standing recommendation that you avoid lenders who use blanket liens altogether. But if you must use a particular lender who employs them, try and negotiate that clause away (it’s probably futile because it’s rock-solid protection for the bank, but you can ask.) 

Next up – compensating balances. 

But what I’d like to talk about more are the restrictions that almost all banks use for business lending. I haven’t talked about these in a few years here, so 2024 seems like a good time to discuss them again.

Before I get into these restrictions, I need to state that these are restrictions that most business lenders and nearly all banks use. But some lenders do not, Crest Capital being one of them. In fact, it’s one of the major advantages we offer our clients. Forgive the commercial, but these restrictions are so impactful to your business that we need to point that out.

Ok, the main restrictions banks use are blanket liens, compensating balances, and annual requalifying. I’ll briefly discuss them below, and subsequent posts will discuss each individually.

• Blanket Liens – This is where the bank throws a lien over your entire company, which puts a lien on every single piece of equipment you own. So if you borrow money to buy a vehicle, the bank puts a lien on everything – tools, machines, other vehicles, office furniture, etc. Since they now have liens, you can’t sell any of it without an ok from the bank. Obviously, this isn’t optimal.

• Compensating Balances – The bank will want you to keep a minimum balance in an account with them. This minimum is usually 80% of the loan. So if you borrow $100k, you need to keep $80k on the sidelines in the bank, and not touch it. So… aren’t they kind of lending you your own money?

• Yearly Requalification – The bank will look at your finances every year. If they don’t like what they see, they can call in the loan immediately in full, even if you never missed a payment. And because of the previous two clauses – they have your money locked up and a lien on all your equipment – enforcing this is a breeze for them, and a nightmare for you. 

It’s very important to be aware of these restrictions, as they are buried in the fine print, and are unlikely to be discussed with any great clarity or detail. But I’ll discuss them all in detail over the next few posts – stay tuned.

The details of each will vary depending on your lender, and what one lender calls Application-Only may differ from what another lender considers it, but in the big picture, most equipment finance applications will come down to one of the two.

The primary difference between them is how much information you are asked to give, and how deep the lender needs to investigate your credit and finances.

At Crest Capital, we have a distinct line between the two: for most equipment financing and leasing deals under $250k, we use Application-Only. For larger deals, we use Financial Disclosure. 

Let’s talk about Application-Only today:

Application-Only Equipment Financing

Application-Only equipment financing is exactly what it sounds like – one simple application is all you need to fill out. And it’s literally only one page. 

This offers a distinct advantage to our customers. They do not need to fill out a bunch of forms, or drag out the tax returns and financial statements to finance a few machines, vehicles, or similar. Many other lenders will want much more for even small financing amounts, so this is a differentiator for Crest Capital.

So what information do we require? You can see the Application-Only equipment financing form on our website, and even download a copy if you prefer to email or fax it. 

But the gist of it is we need some company information; basic details and info on company principals; bank info; a lending reference; and (of course) the details on the equipment you wish to finance or lease, including the price and how long you wish the term to be.  

From this information, we can check public credit records for company principals and the business. The normal consumer credit reporting agencies are checked, as well as business credit specialists such as Dun and Bradstreet, LexisNexis, and several others. 

The entire point of application-only financing is to use public records, and not detailed financial reports. Of course there are some companies with long credit histories that can easily stand on their own, but also many companies without years of credit in the business name. Hence the mix of personal and business credit sources used.  

A large upside to using public records is speed. Most of our Application-Only deals have an answer in a business day or even less.  

Note that the $250k mentioned earlier is our number for application-only financing. Another lender’s number for the same process may be lower (and may even be zero – for example, most banks typically want more paperwork.) Every lender is unique in this regard. 

So the key takeaway for you is when you hear the words “Application-Only” for equipment financing, think “easy / fast”, as that is generally the case. 

Something really big happened at the last Federal Reserve meeting on June 14th – rates did not go up for the first time since January 2022. They didn’t go down either – they just held fast. 

However, let’s not break out the party hats yet – in reading the tea leaves from statements made, it seems more hikes will be coming. However, it also seems the shock and awe type increases of 75 basis points and such are over for the time being. That’s good news. We can deal with smaller hikes, but those big ones are tough for everyone.

This tells me that rates may not return to the lows we experienced through most of the 2010’s for a very long time, if ever. During those years, it was incredibly inexpensive to borrow money. However, simple logic tells us that the cheaper something is, the less value it has. In this case, we’re talking money, so if you make money cheap, that can technically be a precursor for inflation. As a result, we’re going to be living with rates higher than recent times, but definitely not out of line historically either. 

This also tells me something else: you can borrow with confidence that you won’t be left out in the cold. Even if you borrow and lock into a rate, and sometime late next year rates begin to fall, they aren’t going to fall by an amount that’s going to make a huge difference to most readers here – 25 basis points at a time (which will likely be the amount of any 2024 decreases) is not going to make much of a difference unless you are borrowing in the millions/tens of millions.  

I’ve been saying this for a year-plus now – if you need it, go buy it. That’s good business. 

Ok, onto other news: I said this in my prediction post: “If they don’t implode, I like the Brooklyn Nets to win it. It’s not fair to pick a second team and have it count, but if it did the Denver Nuggets are a dark horse.”

Well, I’m now counting it. Because the double dip happened: if you follow basketball at all, you know the Nets DID implode, and the Nuggets won it all. So that was a pretty good prediction. 

And let me sign off with this: my Braves prediction is looking strong so far.  

Fletch,

I’ve been reading your thoughts about rates but I’ve been holding off getting new gear because I was too scared to borrow when rates were rising. I clearly should have a year ago but that’s hindsight. But today even though I really need some new machinery I’m still hesitant to commit to a long-term loan because rates could start falling. A friend of mine suggested I lease but I’m hesitant there too. Can you talk me into it?

First of all, smart move in asking The Lease Guy to talk to you about a Lease!

But yes I do understand your dilemma and it’s not uncommon. For people who have held off buying equipment the past year, they are almost to the point where they feel like they must stay the course.  

I will say I don’t think rates are going to lower, so you’re probably safe in just financing what you need. But you asked me to talk you into a lease, so here goes:

Get an FMV Lease, which stands for “Fair Market Value” lease. Take it out for 24 to 36 months. This means you aren’t locked in as long as a traditional loan, but most importantly, it gets you the equipment you need right now. And at the end of the lease, you have the option to buy the equipment at the fair market value. If rates are lower and you like what you have, go ahead and buy it. If neither of those things are true, hey, lease another. 

Now, because an FMV lease might be an operating lease, it could be structured so it isn’t on your books as an asset, meaning you can’t take a Section 179 Deduction on it. However, as it IS an operating expense, you can deduct the lease payments on your taxes. While it’s not as big as Section 179, it’s still pretty attractive.

Plus, with the FMV lease, you’re really only paying for the portion of the equipment’s life you are using, which means your payments are going to be pretty manageable.

Lastly, whatever your feelings are, it’s never a good idea to “need” new machinery or equipment, but not get it. It’s hard to competitively operate that way. So if the lease gets you the equipment now, and you feel good about the financials, there’s almost no downside.

Hope that helps!