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.

Defaults are when borrowers, at some point in the loan’s life, cease making their payments. For this post, the reasons why are immaterial – at the end of the day, all that matters is the lender is out not only a (sometimes large) portion of the money they lent, but they are also out of the expected revenue from the interest. Since most businesses use some form of projected/expected income to operate, this is doubly bad for a lender. And no, “writing it off” does not make a lender whole by any stretch.

But it isn’t just the money/revenue lost. Most of the time, there was some form of collateral involved with the loan, which now must be repossessed. This costs money, as someone has to be paid to collect it. One other issue here: Since the borrower is generally in some kind of financial straits, this is typically not a pleasant experience. 

In addition, in most cases, the collateral does not make the lender whole. They still need to sell the item, and they almost never recoup even close to what is owed.

There’s another aspect to defaults that often goes unnoticed by those outside the lending industry: how defaults make a lender look to regulators. Too many defaults will often bring increased regulation on the lender, and increase their capital requirements. Nevermind that perhaps the defaults were an anomaly and not really the lender’s fault. That won’t matter to the regulators; to them, the lender is writing too many risky loans and will be treated as such.

Lenders use an immense amount of data to qualify borrowers, and, much like the insurance industry, attempt to predict default rates based on various lending criteria and borrower/loan profiles. Now, of course, lenders can’t predict which specific borrowers may default, but they do have to honor what the data tells them about the aggregate. These predicted default rates are factored into the lender’s overhead and become part of the rate equation.

Despite the lender’s best efforts and the borrower’s best intentions, defaults in the lending industry are inevitable and must be accounted for.

One thing that’s helpful in understanding this is to look at money lending as an investment for the lender. If it’s a private lender (like Crest Capital), the lender is lending its own funds. And the rate they charge for the risk they take must significantly surpass whatever they could earn safely. 

To see this in action, look at treasury notes. Right now, a 5-year treasury note is paying mid-4’s to close to 5%. So a lender can put their money there with no risk at all. Why on earth would they ever lend it to anyone for even close to that? The answer is, they wouldn’t. Nor would you. Makes sense, right?

Now look at lenders like banks. Banks (generally) do not use their own capital for lending – they use depositors’ capital, which they pay interest on. So whatever they charge has to make sense financially here, too.  And while individual loans and circumstances could be different, in general terms, any lending needs to be well above what they are paying in interest – it’s the only way a lender can survive.

Next we’ll talk about overhead. Like any business, lenders have overhead, from property taxes to the electric bill and more. But what isn’t known is the sheer amount of legwork required for some loans.  Some of the more exotic loans take a lot of paperwork and back and forth. And any smart lender will do at least a little UCC homework on a used equipment financing deal. This costs time, which equates to salary/money.  

Capital requirements are another “cost of money” issue. Lenders are required to keep a certain percentage of capital on the sidelines (earning next to nothing), and different loans can have higher capital requirements, especially if they are of the riskier type. 

We’ll be going over defaults in detail in another post, but defaults DO factor into the overall cost of funds as well.  

No way around it – money costs money, and it’s going to be reflected in the rate a lender charges.

In plain terms, most lenders want to know what you are going to do with the money they lend you. This is true for consumer loans (your personal loans and credit cards – which have no defined use – are going to cost more interest-wise), and it’s especially true with business lending.

The reason it’s especially true in business lending is the intended use of the loan is often related to a borrower’s ability to repay the loan in the first place. Putting an equipment financing slant on it, let’s say a company is borrowing money to finance heavy equipment. The lender (Crest Capital of course) knows the company is going to use this heavy equipment to earn more revenue. All else being equal, that’s much preferable to a lender than needing money for an undisclosed reason.

In addition, if the loan’s purpose is fully disclosed, the lender has an idea of the collateral involved. A good example is a piece of machinery that has a strong preowned market – since the machinery will be used as part of the collateral in almost all cases, the lender knows they can recoup some of their money if things go bad. This will usually result in a better rate.

This is very easy to see on the consumer end as well – this is why loans for things like a house have a lower rate than a car, which has a lower rate than a personal loan or a credit card. The house can be foreclosed on, and the car can be repossessed. But those concert tickets and dinner that night that were paid for by a credit card cannot be recovered. Hence the higher rate. 

Makes sense, right?  In fact, it’s time for our first tradeoff alert:

Tradeoff Alert: All else being equal, funds for specifics with resale value will usually result in a better rate.

Loan term will also matter. In general terms, the faster a lender gets their money back, the lower the rate they are willing to offer. This is why a 36-month term will typically have a lower rate than a 60-month term for the same item. This can sometimes vary when lenders or vendors run specials, but in most cases, shorter terms result in a lower rate.

So there you have it – loan type / intended use / loan term… they will all factor into the rate you pay. 

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.   

The misconception is the lowest rate is everything. And it’s not even close to being everything. In fact, I would argue that in the amounts we generally finance (typically between $5,000 and $500,000), the rate is, at best, the fourth or fifth most important thing, behind collateral, several restrictions, and terms.

In fact, I know someone is quite knowledgeable about business when their first question is, “What are the collateral requirements?” or “How flexible is the repayment structure?”. People newer to business typically lead off with “What is the rate?”

Here’s a quick example: John and Mike both borrow $85,000 for a delivery truck. John’s rate is 7%. Mike’s is 8%. 

John’s 5-year payment is $1683.10.  Mike’s is $1723.49.

So on the surface, John’s payment is roughly $40 less per month, or $480 a year. Multiply that by five years, and that comes to $2400. 

Ok, it’s not chump change, but it’s not that big of a factor over five years, either.

But, in John’s loan, he had to put up his house as collateral, as well as having a lien on the truck. That’s why the rate was lower – lessened risk to the lender.

In Mike’s delivery truck loan (written by Crest Capital of course), the truck lien itself was the only collateral. 

John risked his home for $2400 over five years. Did he really get a better deal? 

I don’t think he did. Most people (and any spouses/family members also living in that house) would agree. 

As I go through this entire series, we’ll run into a number of these “tradeoffs”. I’ll highlight them with a Tradeoff Alert. 

As this upcoming series will show, there’s a lot that goes into a rate, and there are tradeoffs. And when it comes to small business borrowing, the lowest rate is usually not the best deal.

Will borrowing costs come down? Not as fast as everyone would like. While lenders’ rates typically follow the Federal Funds Rate directionally, the relationship isn’t as straightforward as many might expect. Lenders adjust more slowly, cautiously, and incrementally than the Fed. A 50 basis point Fed rate cut doesn’t mean an immediate equal reduction in lending rates. With the higher default rates across lending sectors in 2024, lenders will likely reduce rates more slowly than Fed cuts as they weigh multiple factors beyond the Fed’s actions. Borrowers shouldn’t expect quick or one-to-one reductions in lending rates following Fed cuts.

I wrote it because there was a misconception that once the Federal Funds rate was lowered that all lending rates would follow on day one. And, as my passage above indicate, they don’t.

But it occurred to me that most people simply take rates on a surface level. That they really don’t know what goes into a lender’s interest rate on any particular loan or lease. So I thought it might be fun to do a little series on interest rates, so you can get a really good idea of how a lender arrives at the rate borrowers pay.

Here are a few sneak peeks of future topics and posts:

• The relationship between risk and the rate
• How loan type and intended use affects rates
• Collateral and rates
• Internal cost of funds and rates (aka, “how much does money cost?”)
• Defaults and rates
• Credit scores and other risk profiles affecting rates
• Benchmark rates and market conditions
• And more!

My goal is to give you a look under the hood at how lenders generally arrive at the rates borrowers pay. There is definitely more to it than meets the eye. I personally find this topic fascinating, and I hope over the posts to come, you will too. 

Not to pat myself on the back (ok, I am), but I was pretty darn prophetic. That’s exactly what happened. But hopefully, the cycle is coming to an end. We recently saw our first rate cut in what feels like forever – 50 basis points was the number.

But what does the rate cut mean for the economy? Does it mean inflation has been tamed and won’t come back? Does it mean the cost of borrowing will come down? Does it mean we’ll never see another rate hike?

The answer to all of those questions is impossible to nail down. And none of them will involve a speedy resolution. 

Inflation has proven sticky, and while rates of increase have slowed, the cumulative/compounding nature of this prolonged inflationary period means that price levels are now structurally and substantially higher than pre-2022 baselines. The reality is even in the best of times we have inflation. The cost of goods will still increase annually, just like they always have.

Will borrowing costs come down? Not as fast as everyone would like. While lenders’ rates typically follow the Federal Funds Rate directionally, the relationship isn’t as straightforward as many might expect. Lenders adjust more slowly, cautiously, and incrementally than the Fed. A 50 basis point Fed rate cut doesn’t mean an immediate equal reduction in lending rates. With the higher default rates across lending sectors in 2024, lenders will likely reduce rates more slowly than Fed cuts as they weigh multiple factors beyond the Fed’s actions. Borrowers shouldn’t expect quick or one-to-one reductions in lending rates following Fed cuts.

Will there ever be another rate hike? History suggests it’s virtually certain. While the timing is unpredictable, our economic cycles have always involved periods of rising and falling interest rates. 

So what do these rate cuts mean for you? The immediate impact may be smaller than you hoped, but if you need equipment now or eyeing a great deal, go get it. Current lending rates are likely to be around for a while, and prices will still go up. Waiting always costs you.