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.   

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. 

Hey Fletch, I know you always tout getting equipment when you need it but aren’t rates coming down soon? Wouldn’t it be better to wait? Dave P.

Hi Dave,

Honestly, assuming the equipment will earn you revenue, no, it is not better to wait. There are three reasons for this. The first is, as I recently posted, Lending rates are not a one-to-one correlation with Federal Funds Rate movement. Lending rates will stay steady for some time before they follow suit and slowly lower. You may be waiting for quite some time.

The second reason is inflation is still here. Annual price hikes are common in many industries. Waiting, especially at this time of year, almost always ensures you will pay more. 

Lastly, it’s like I mentioned earlier – getting equipment when you need it earns revenue. Don’t miss out on that. 

I hope this helps.

Fletch

Hi Fletch, I am selling a dump truck and the second I sell it I want to buy a larger one. I have it all picked out and am ready. What are the chances you can handle the financing for the sale and the financing for my new dump truck at the same time? Mark

Hi Mark,

That’s a great question. Of course, it would depend on your buyer’s details. But assuming they qualify for financing and everything checks out across both deals, we can work with everyone so there’s little to no gap between the transactions. Let us know and we’ll get to work.

Fletch

Hey Fletch, You picked the Braves to win the world series but they got bounced in the first round. What’s up with that? Pete M.

Pete,

There’s a reason I don’t make my living as a gambler! But I did hit with the Celtics, right? I usually hit at least one a year, so there’s that.

I did want Atlanta to win. But they didn’t. And of course, there’s no crying in Baseball…

Fletch

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.

First, not to pat myself on the back regarding my prediction skills, but I did say back in Feb 2023 that rates would continue to rise for a bit (they did) and then hold fast for a long time (they are). 

Now with every Federal Reserve meeting, the question is “when will cuts start?” 

Nobody knows the real answer, but I’ll say “not for a while yet”. Some optimists were saying we’d have 4-6 cuts this year. That was never going to happen, but now it’s starting to look like we may get one to two at best. And none is a definite possibility.

So why is that? Inflation is proving stubborn, especially the so-called “last mile” to the target of 2% (which may not be realistic). But the second part is, at least on a reported Macro level, the economy seems to be humming along. 

Honestly, I’m not so sure the picture is as rosy as we’re being told it is. To give one example, job numbers have a way of not telling the real story (e.g., people fall off unemployment rolls and are not counted anymore, but still don’t have a job.)  Also, someone with two part-time jobs would usually prefer one full-time job, but the numbers don’t reflect that.

This is all my way of saying: THIS is the environment we have right now, and it’s the one we have to work with. I’ve talked recently about equipment financing and growth and not waiting around for the “economic ok” from the news. Because you’re not going to get the real story.

If your company is doing well, keep doing what is working. In fact, do more of it. Add another crew. Offer more of that service everyone wants. Make the building better. Etc. That’s how you expand when things are going well.

If you are on the other side, and things were better a year or three ago, you should consider changing things up. Offer another / different service. Maybe try serving a different geographic area. Do something. Because things won’t get better on their own. 

The current business environment is what we have, and it will be here for a while. Make it work.

The reasons are many, but the big one is stability. Knowing what your monthly payment is going to be for the entire term of your equipment loan is important. It allows companies to better forecast and plan ahead; it allows them to set budgets more accurately; and it allows them to know exactly what a piece of equipment will cost.

Fixed rates for equipment financing can also be a hedge against rate increases, which are never well-received. It’s interesting that rate drops are never seen in quite the same light. For example, if I take out a loan, I am obviously ok with the payment. If rates go down a slight percentage, I might say “hmmm, would have been nice if they dropped last month when I financed, but oh well…” and I move on, not thinking about it again.

But if rates rise, and I’m comfortably locked in at a lower rate? Heh, then I’m imagining myself as a financial wizard, and probably won’t shut up about it.

Conversely, adjustable rates are a real roller coaster. Sure, if you get in at the exact right time and rates start falling, you’re going to be happy. But those perfect times are few and far between. And never mind rates rising and your payment going up – that will give any businessperson sleepless nights. 

The bottom line is adjustable rates are risky, and can really hamper a company if they go up. You certainly wouldn’t BUY a piece of equipment from a vendor that said “right now the price is this, but if we feel like it later in term, we’ll raise it to that”… so why would you finance under that same scenario?  

Nope, the jury is back in record time: fixed rates are better for equipment financing. Fletch has spoken. 

To illustrate this, let’s pretend I’m an equipment financing company. I’ll loan you a hundred dollars. You agree to repay me $9 a month for 12 months. This means you will repay me $108 – $100 principal, $8 interest (hey, Fletch needs to eat too, you know).

But Joey (who is playing the part of the bank) says: “wait – I’ll loan you the $100, and you pay me back $8.50 a month, plus a little more based on the economy… maybe it’ll be as low as $8.75, but it could be as high as $10, $11, $12… who knows?”

So who do you want to borrow money from? Me, or Joey? With me (an equipment financing company), you know exactly how much you will be paying for the life of the loan. No surprises, no “oh gee, interest rates went up… sorry”. Your accountant can plan and budget.

But with Joey, you can’t plan for much. This is because Joey’s rate can change with interest rates and the economy. And really, does anyone expect rates to go lower?  I sure don’t. And to be fair, when you are borrowing for equipment, the numbers are a lot bigger than my little example above. Thus, little fluctuations in the interest rate can mean a sizable chunk of money – enough of a chunk to give your accountant indigestion. And they don’t like that.

Any businessperson will tell you – it’s better knowing than not knowing. And with an equipment financing company, you just “know” what you are going to pay, and that’s a good thing.

So tell Joey to jump in the lake. Deal with Fletch.