You may think you know, but the truth is sometimes hard to decipher, especially with interest rates…
These days, people are on the lookout for “fake news” disguised as the truth. The proliferation of bad actors presenting information in ways that are not 100% accurate and honest has been true in the world of interest rates in the Equipment Financing industry for quite some time.
Breaking News: Not Everyone Is 100% Forthcoming about Finance Interest Rates
In an ideal world, if you were to ask a simple question, you would get a straightforward and honest answer. But that is not always the case. Since the “rate” is a key criterion for most decision-makers, capital equipment vendors, and finance company sales reps are motivated to present the lowest numbers (which may not be the true interest rates, usually known as the annual percentage rate or APR, a customer will pay). While many will give the honest and best answer, some will artfully refer to interest rates that sound kind of like the right thing but are also not completely accurate, and the small minority will flat out lie.
If your capital equipment vendor’s sales rep insists on explaining the rate for your finance transaction instead of letting you talk to the finance guy, then that is a red flag. In this case, the chances are higher that you may not be getting the true interest rates. Your capital equipment vendor rep can always claim “plausible deniability” because they are not a finance expert.
If you have questions about the financing, always insist on speaking directly with the equipment financing expert.
Annualized Rate vs Stream Rate vs Annual Percentage Rate
Let’s use a simple example to illustrate two ways to quote a rate that is dishonest but not outright lies, and what constitutes the proper way to calculate your interest rate.
- Amount financed: $100,000
- Term: 60 months
- Payments: in advance
- Monthly Payment: $1,912.51
- End of Term Purchase Option: $10,000
Annualized interest rate = 4.95%
- How it’s calculated: (Sum of payments – Amount financed) / Amount financed / # years ($124,750 – $100,000)/$100,000/5 = 4.95%
- The Fallacy: This calculation is incorrect because fixed-term equipment finance transactions are almost always calculated like your mortgage – i.e. blended payments of interest and principal. This means the principal balance of the Amount Financed reduces over time. This calculation ignores the amortization of the amount that was originally financed.
Stream Rate = 5.75%
- How it’s calculated: Net present value of Amount Financed and lease/loan payments (you would need Excel or time value of money calculator for this one).
- The Fallacy: This calculation ignores the End of Term Purchase Option price. If the customer has the ability and intention to return the equipment at end of term, then it may be appropriate to ignore the Purchase Option Price. However, a balloon payment at the end of a loan is a compulsory payment and most leases with stated residuals require the lessee to exercise that residual at the Purchase Option Price.
Annual Percentage Rate (APR) = 8.67%
This is what most people mean when they are talking about the true interest rate.
- How it’s calculated: Net present value of Amount Financed, lease/loan payments and Purchase Option price
- You could use the “=Rate” function in Excel or a time value of money calculator to verify the calculation
Other Ways Lenders May Disguise a Higher Borrowing Cost
Multiple payments in advance – Loans are typically payable in arrears while leases and equipment finance agreements are payable in advance. Some lenders calculate payments as if they were spread over the finance term, but then require more than one payment to be made in advance. By making multiple payments in advance, the customer effectively pays a higher interest rate because the amount being financed is reduced.
Security deposit – If your lender deems your transaction to be riskier, they may require you to pay a security deposit that is held until you repay the lease or loan. Some lenders give you credit for the amount of your security deposit when they calculate your payments, although most do not. The security deposit also increases your borrowing costs.
Large admin/transaction fees – When comparing finance offers, you should include the transaction costs that are added on top of monthly rent or other payments. These costs can include: commitment, administrative or other up front fees; annual review or renewal fees; partial or interim rent (i.e. a pro-rata rent payment charged to cover the period between the start date of the finance contract and the first payment date); etc.
Fair market value (FMV) purchase option – There is a place and time for an FMV lease. (Check this space in a few months for a blog post dedicated to various lease structures.) The FMV structure was typically used to allow the lessor and lessee to treat the financing as an operating lease for accounting and tax purposes. With changes to the accounting rules, the capital lease vs operating lease distinction is no longer as relevant for accounting purposes. Lessors still use the FMV structure for various reasons, one of which is to improve the overall yield in a transaction. If you still need the equipment at the end of the lease term, your FMV will be determined based on its “in place, in use” value. That generally means the lessor will charge you as much as it feels you will pay to avoid the convenience of having to return the equipment and purchase a replacement. This value is often more than what it would cost to buy the same equipment in the secondary market.
Factors that Typically Impact Rate and Payments
Lenders consider several factors when determining what interest rate to apply to a particular transaction. Each lender has its own criteria, weightings, risk tolerance, the base cost of funds, etc. Here are some of the most important factors in relative order of importance:
Customer’s credit history – You are in the best position to command great rates if your business is well-established with a demonstrated history of paying its bills on time. Even better if your business has borrowed a similar amount in the past and made all payments as agreed.
Customer’s financial profile – Lenders need to know your business will be able to repay its debt. They make a judgment call based on how much equity you keep in the business, short term liquidity, how much leverage the business carries relative to similar companies in the same industry, and other standard financial ratio analysis.
Time in business – Surviving and thriving through various cycles with the same ownership is a great indicator that your business will continue to thrive in the future.
Equipment being financed – Lenders use the term “collateral value”.
- A hard asset that retains its value well and has a broad aftermarket has more collateral value than a specialized asset with a limited secondary market. This is true regardless of how much revenue the asset can generate. Think of a wheel loader that is almost indestructible and can easily be sold at auction compared with a robotic system that has been configured for a specific production line.
- Equipment that is essential use for a business is more desirable as collateral than an asset that is “nice to have”.
- Tier 1 equipment is easier to get financed. Briefly, “Tier 1 equipment” means the manufacturer is well-established, the equipment is reliable, the sales channel is stable and the manufacturer and seller provide strong maintenance and marketing support. If your equipment performs well with less downtime and you get good marketing support, you will be more likely to succeed and repay your lease or loan. As a matter of fact, this little point is so important that one day I’m going to write an entire blog post about why customers should only deal with strong manufacturers and vendors.
Amount financed and finance term – Many lenders’ pricing guidelines are based on amount and term. The same costs associated with adding a lease or loan to the portfolio end up being much less proportionately as the transaction size increases. So, lenders will often charge less as the transaction size increases. The wholesale cost of funds is typically higher for longer-term obligations, meaning a 7-year lease will usually have a higher rate than the exact same lease with a 5-year term.
What Should You Do with This Information?
Here are a few simple suggestions:
- Deal with someone who is reputable and trustworthy. How do you know? A reference from someone you trust, BBB rating and your gut feel is some ways.
- A strong web presence is a good indicator of a leasing company that is trustworthy. People who are subject matter experts and are easy to find generally have less to hide.
- Get it in writing in an official email format or a real piece of paper… with all the details. A finance rep who is not telling you the truth will usually answer your specific questions with general answers. (For example, Q: What’s my rate? A: It’s like a credit card rate. Q: So, like 19%? A: Somewhere in that range.) Confirm conversations in writing and avoid text messages and other electronic communications that can be deleted or manipulated.
If in doubt, call one of Armada’s equipment finance professionals. We know capital leasing and are happy to review your deal and let you know whether the actual documents reflect your understanding of the deal. We can answer all of your questions on interest rates and more. We live and love equipment financing and plan to be in this business for a long time.
When looking for equipment leasing, equipment financing, assistance with working capital loans, or searching for leasing companies that you can trust, you can rely on Armada. Our mandate is to be truthful and let you know where you stand. We work for you to structure the right leases and financing to you to achieve your business goals.
Do not hesitate to get in touch to discuss your equipment financing options. Our knowledgeable and friendly capital equipment financing professionals are happy to serve you to help you grow your sustainable and profitable business.
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