At the risk of being a bit basic, let’s understand what collateral is – it’s something of value that a borrower puts up to “secure” a loan. And if the borrower defaults, the lender can take and sell the collateral to help satisfy what is owed. 

So a loan with collateral is a “secured” loan, and one without collateral is considered “unsecured.” For example, most credit card lending is “unsecured”.

In many types of lending, the collateral is usually the item the loan is being used for. This is especially true in consumer lending. A car loan or a mortgage is typically secured by the car or home itself, and the lender will “repossess” them if the loan is defaulted on. 

Now, the better and more valuable the collateral, the better the loan terms and rate may be. This is partially why a new, high-end luxury car may have a lower rate than a used car and why a home/land will typically have a lower rate than most auto loans – the collateral is simply more valuable. 

In terms of equipment financing, there are two common collateral types: the equipment itself and what’s called a blanket lien. Let’s look at both:

• The Equipment Itself: Some lenders, Crest Capital amongst them, only require the financed equipment itself as collateral. This means if the loan is defaulted on, the lender can take possession of the equipment. The equipment will have a lien on it, which legally prevents the borrower from selling the equipment. Once the loan is satisfied, the lien is lifted. 

In general terms, “equipment-only” collateral loans are offered to profitable companies with good credit. This is because, in most cases, the equipment is usually worth less than the loan balance and carries repossession costs. So, the rate offered, while strong and competitive, will likely not be the absolute lowest.

• Blanket Liens: Blanket liens are when a lender puts a lien on an entire company, covering all assets. This is extremely secure for the lender, as a defaulting borrower can be liquidated until the entire is satisfied. But it’s a large drawback for the borrower, as every asset the company owns now has a lien on it. This greatly reduces financial flexibility – a company with a blanket lien cannot sell or even give away any asset without lender permission. Blanket liens are used by almost all banks, which is why banks often carry the lowest equipment financing rate.

Tradeoff Alert: Accepting an equipment financing loan with a blanket lien may result in the lowest rate by a point or two but will severely restrict a company’s financial flexibility and operations. If you are unsure about the ramifications of such a situation, ask your accountant.       

Collateral is a necessary part of lending – in short, most loans would not exist without some form of collateral. However, the types and amount of collateral can vary greatly and can definitely affect 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.   

Clauses like blanket liens, compensating balances, and annual requalification are common and written into almost every bank business loan. They may or may not be clearly discussed, and it’s up to the borrower to understand exactly what they are getting into. 

This brings up a simple question: “can I avoid these?”

The answer is not as simple (but it can be – you’ll understand in a minute).  

If you are insistent on using the bank, there may be no way to avoid them. I would always recommend you ask about these and insist the bank discloses them in plain English. Your loan officer might be a little surprised when you mention blanket liens, but they don’t know you read The Lease Guy so we’ll forgive them.

You can ask for these clauses to be dropped, but I wouldn’t get my hopes up. I suppose for the bank’s very best long-term, high-revenue customers they might, but even then the chances are slim. You see, these clauses are part of the bank’s normal operations – they mitigate risk on loans greatly, and this risk mitigation is one reason the bank usually offers the lowest rate. 

A better, and much simpler, way to avoid these clauses is to use a business lender / equipment financing partner that doesn’t use them. Like Crest Capital – we do not use any of these clauses. The only lien you’ll see from us is the standard lien on the piece(s) of equipment we are financing, and that’s it – the rest of your assets are just that: YOUR ASSETS. We also don’t care about compensating balances, and once we say “yes”, that’s that – we leave you alone afterwards.  

Because we don’t use these draconian clauses, our rates will be a point or so higher in most cases. So you have to ask yourself, how much is a point or so of interest worth to you? To us, it’s a no brainer. In fact, to most astute businesspeople, once these clauses are pointed out and dissected, the choice is pretty easy. 

Forgive the obvious plug, but it is what it is. These restrictions are real, they hurt, and we don’t use them. Simple as that.

It is true that equipment financing can be similar to automobile financing in terms of the equipment being part of the collateral in the big picture. But only to a degree, and it also really depends on the equipment. Let me give you a few examples of equipment that isn’t great collateral:

• Specialized equipment for specialized industries – This is probably one of the bigger issues with using equipment as collateral. If the equipment is even somewhat specialized, it can be tough to sell, as there’s just not a big market for it. For example, think about the machine that makes those little hard candies that come on a paper strip – you know what I mean, right (they’re right next to the wax bottles of colored liquid). Well, a machine does that, and it’s not a machine that every business can use. So if it has to be repossessed, the line of buyers might be small indeed. My sister (who loves that candy) might even pony up a few dollars for a used candy maker.

But it doesn’t even have to be a super-specialty piece of equipment. Even something like a large printing press might not be easy to sell these days.

• Computers and other electronic equipment – No brainer here. Computer equipment ages like no other equipment. And almost any electronics aren’t far behind. How’s that monster 48” rear-projection TV doing? Call me on your flip phone and tell me, ok? If I don’t answer, hit up my pager.
• Software – Again, no brainer. Especially software that’s named after a year (anyone buying Office 2010 these days?) Plus, you really can’t repossess software.
• Vehicles – Surprising? Not really. Most vehicles lose value annually. Although after a huge drop when it leaves the lot (assuming a new vehicle here), the rate of depreciation is slower. Plus, it also depends heavily on the vehicle and industry. Some vehicles are easy to resell (you can always find a willing buyer for a dump truck), but some aren’t (not a huge demand for septic trucks).

These are just a few examples of equipment that doesn’t make great collateral in an equipment financing deal. Maybe next time I’ll explore things that make very good collateral.