Next up in our series of how lenders arrive at interest rates is looking at the true cost of funds. It could also be entitled “How much does money cost?” because, in essence, that’s exactly what it is.
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.