You may believe you know what's going on, but the truth can be difficult to discern, especially when it comes to interest rates.
People nowadays are on the lookout for "fake news" that is disguised as the truth. For quite some time, there has been a proliferation of bad actors presenting information in ways that are not 100 percent accurate and honest in the world of interest rates in the Equipment Financing industry.
Breaking News: Not Everyone Is 100% Forthcoming About Interest Rates in Finance
In an ideal world, if you asked a simple question, you would receive an honest and straightforward response. However, this isn't always the case. Capital equipment vendors and finance company sales reps are motivated to present the lowest numbers because "rate" is a key criterion for most decision-makers (which may not be the true interest rates, usually known as the annual percentage rate or APR, a customer will pay). While the majority will give the truthful and best answer, some will cleverly refer to interest rates that sound right but aren't entirely accurate, and a small minority will flatly lie.
It's a red flag if your capital equipment vendor's sales rep insists on explaining the rate for your finance transaction rather than letting you speak with the finance guy. In this case, the chances of you not getting the true interest rates are higher. Because they are not finance experts, your capital equipment vendor representative can always claim "plausible deniability."
Always insist on speaking directly with the equipment financing expert if you have questions about the financing.
Annualized Rate vs Stream Rate vs Annual Percentage Rate
Let's look at a simple example to show two ways to quote a rate that are dishonest but not outright lies, as well as how to calculate your interest rate properly.
Amount financed: $100,000
Term: 60 months
Payments: in advance
Monthly Payment: $1,912.51
End of Term Purchase Option: $10,000
Annual 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 in the same way as a mortgage, with blended interest and principal payments. This means that the Amount Financed principal balance decreases over time. This calculation disregards the amortization of the original loan amount.
Stream Rate = 5.75%
How it is 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 disregards the End of Term Purchase Option price. If the customer has the ability and intention to return the equipment at the end of the term, it may be appropriate to disregard the Purchase Option Price. A balloon payment at the end of a loan, on the other hand, is a mandatory 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%
When most people talk about the true interest rate, they are referring to this.
How it is calculated: Net present value of Amount Financed, lease/loan payments, and Purchase Option price.
To check the calculation, use Excel's "=Rate" function or a time value of the money calculator.
Lenders may hide a higher borrowing cost in other ways
Multiple payments in advance – Loans are typically paid back in arrears, whereas leases and equipment finance agreements are paid up front. Some lenders calculate payments as if they were spread over the term of the loan, but then require multiple payments to be made in advance. Because the amount financed is reduced by making multiple payments in advance, the customer effectively pays a higher interest rate.
Security deposit – If your lender considers your transaction to be more risky, they may require you to pay a security deposit that will be held until you repay the lease or loan. Most lenders do not give you credit for the amount of your security deposit when calculating your payments. The security deposit raises your borrowing costs as well.
Large admin/transaction fees – When comparing finance options, consider the transaction costs that are added on top of monthly rent or other payments. These expenses may include: commitment, administrative, or other up-front fees; annual review or renewal fees; partial or interim rent (a pro-rata rent payment charged to cover the period between the start date of the finance contract and the first payment date); and so on.
Fair market value (FMV) purchase option – An FMV lease has its place and time. (Check back in a few months for a blog post on various lease structures.) The FMV structure was typically used to allow the lessor and lessee to account for and tax the financing as an operating lease. Because of changes in accounting rules, the distinction between capital and operating leases is no longer as relevant for accounting purposes. Lessors continue to employ the FMV structure for a variety of reasons, one of which is to increase the overall yield in a transaction. If you still need the equipment at the end of the lease term, its "in place, in use" value will be used to calculate your FMV.
Factors That Typically Impact Rates and Payments
Lenders consider a number of factors when deciding on an interest rate for a specific transaction. Each lender has its own set of criteria, weightings, risk tolerance, base cost of funds, and so on. In order of importance, here are some of the most important factors:
Customer credit history – You are in the best position to command low rates if your company is well-established and has a track record of paying its bills on time. Even better if your company has borrowed a similar amount in the past and made all agreed-upon payments.
Customers' financial profiles – Lenders want to know that your company will be able to repay its debts. They make a decision based on how much equity you retain in the business, short-term liquidity, the amount of leverage the business carries in comparison 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 an excellent predictor of future success.
Lenders use the term "collateral value" to describe financed equipment.
A hard asset with a broad aftermarket and a good value retention has more collateral value than a specialized asset with a small secondary market. This is true regardless of the asset's potential revenue. Consider the difference between a wheel loader that is nearly indestructible and can be easily sold at auction and a robotic system that has been customized for a specific production line.
Equipment that is required for the operation of a business is more desirable as collateral than a "nice to have" asset.
Tier 1 equipment is less difficult to finance. In a nutshell, "Tier 1 equipment" denotes a well-established manufacturer, reliable equipment, a stable sales channel, and strong maintenance and marketing support from both the manufacturer and the seller. You will be more likely to succeed and repay your lease or loan if your equipment performs well with less downtime and you receive good marketing support. In fact, this small point is so important that I plan to write an entire blog post about why customers should only deal with reputable manufacturers and vendors one day.
Finance term and amount financed – Many lenders base their pricing on the amount and term of the loan. As the transaction size grows, the same costs associated with adding a lease or loan to the portfolio become much less proportionately. As a result, as the transaction size grows, lenders will often charge less. Longer-term obligations have a higher wholesale cost of funds, so a 7-year lease will typically cost more than a 5-year lease.
What Should You Do With All of This Data?
Here are a few straightforward ideas:
Deal with a reputable and trustworthy individual. What makes you think that? Some methods include a referral from someone you trust, a BBB rating, and your gut feeling.
A strong web presence is a good indicator of a reputable leasing company. People who are easy to find and are subject matter experts have less to hide.
Get it in writing, either on an official email or on a piece of paper, with all the details. When a finance representative isn't telling you the truth, they'll usually respond to your specific questions with general responses. (For instance, Q: What is my hourly rate? A: It's comparable to a credit card interest rate. Q: So, 19%? A: In that range.) Confirm conversations in writing and stay away from text messages and other electronic communications that could be deleted or manipulated.
If you're unsure, contact one of Raptor's equipment finance experts. We understand capital leasing and would be happy to review your agreement and let you know if the actual documents reflect your understanding. We can answer all of your interest rate questions and more. We are passionate about equipment financing and intend to stay in this industry for a long time.