INTEREST RATES & FACTORS EFFECTING YOUR BORROWING RATE

Today's announcement by the "FED" of a decrease by 75 "basis points" in the "Fed Funds" rate got me to thinking of how confusing the whole interest rate discussion is, and if it's confusing for those of us in finance & lending it surely must be somewhat confusing to the occasional broadcast or media equipment finance borrower. I thought I would devote this article to some of the myths and misconceptions about interest rates. In addition I have added a short list of some of the factors that effect the borrower's ultimate borrowing rate.

COMMON AND MISLEADING INTEREST RATES HYPES
I would like to begin with three uses of rates that are widely (and wildly) circulated. These three market segments often create misconceptions because they are born out of the marketing hype of promotional advertising. These include: 1) Consumer automobile financing & leasing, 2) mortgage loans, and 3) Credit card promotions. As consumers it seems we are bombarded with promotional advertising from Car manufacturers and dealers, mortgage lenders and brokers and credit card lenders. We are often "teased" (to the point of almost believing) introductory credit card promotions, Zero Percent or 1.9% automotive financing and mortgage loan financing that offers a significantly lower monthly payment than our drab 30 year fixed loan that we refinanced just two years ago. As consumers we may "buy into" these interest rate promotions to the point that we begin to think that the "low rate financing" for a car, or the 5.5% ARM for a mortgage or the 0% 6 month introductory "balance transfer rate" on a credit card is the actual rate that everyone is paying and we deserve it too. Then, we ask ourselves why, if the Prime Rate (the rate banks lend to their best customers) is 6.5%, would we not qualify for a better business loan rate if we can get a mortgage at 5.5%, or a credit card at 6%, or a car loan at 1.9%? The answer, of course, is that if something appears to be too good to be true, it probably is! The truth is often found (with a magnifying glass) in the small print on the back of the credit card application, the auto lease or the 30 pages of mortgage loan documents. In each of the three consumer loan categories above the lenders, brokers, lessors all make their target yields (and more) through the use of a wide array of interest rate enhancements that make up for any apparent "good deal" that you are getting.

In the car business manufacturers and dealers subsidize the rates. It is ridiculous to believe that a car dealer is offering true 0% financing when capital is costing GMAC, Ford Motor Credit, Toyota Credit or the local credit union 3%, 4% or 5% plus an equal amount to cover their costs of operating credit centers, lending officers, cost of credit processing, and delinquencies and losses plus achieve a profit margin. In truth the 0% financing is funded within the profit margin of the car, truck, boat, furniture or whatever. The test of this, of course, is to ask the car dealer for a reduction in the sticker price while retaining the 0% financing offer. Depending on the margin that the dealer holds in the automobile there will generally be "Zero" negotiating. It's either a cash or finance deal, you choose. If you pay cash the dealer may choose to "give up" some of the amount of margin that is being used to subsidize the financing. For instance where the dealer is offering 48 month financing at 0% on a $30,000 car the monthly payment is $625. Let's say that today the auto finance company, funding the dealer, needs to achieve a 7.5% yield to cover the cost of capital plus cost of finance administration, credit risk, etc. So by computing the "zero interest payment", of $625, for 48 months at 7.25% we can calculate that the bank would actually pay the dealer, a discounted price of $26,131, for the car. That means that the dealer has $3,869 of margin allocated to finance costs (the amount that is used to subsidize the rate from 7.25% to 0% for 48 months. Caution, in most cases, if you try to negotiate the price (down from $30,000) the dealer will offer some amount less than the full margin of $3,869. The reason is that auto dealer generates higher margins on finance deals, especially leasing, than on cash purchases.

In the arena of mortgage lending take a look at your "Final Closing Statement". Factor in the 30 itemized costs associated your loan, including "points paid" when you add those costs to your loan you will find that 5.5% quickly becomes some higher number. In addition, various types of loans can be effectively expensive if your payment is subject to changes and increase as interest rates change.

The most obvious myth and misconception is probably in the area of frothy Credit Card promotions. While not quite "bait and switch" the marketing could compete with "seven minute Abs". On the front of the mailed promotion, in large and brightly colored letters, they talk about the "low introductory rate", a special deal for you that allows you to pay off other loans and credit cards and have no interest for 3 months or 3.9% for 6 months. However turn the offer over, look at the small print. It says the $50,000 credit line may actually be $1,000 and the interest rate will soon be 18% or 22% or 29%. Add to that you will find that any time you miss a payment there is a $39 fee or a similar "over the limit" charge. Recently it was reported by one credit card company that late charges and over limit fees comprised over 35% of their revenues!

A REALITY CHECK FOR INTEREST RATES IN BUSINESS LOANS AND LEASES
All of this brings me to the discussion about today's interest rate reduction, the announcement by the FED, the reduction by most major banks of their Prime Rate to 6.5%, and the resulting expectation by the business community for lower borrowing costs. Certainly competition and market depand will encourage lenders to adjust rates to qualified customers, however I think it is important to note that the Prime Rate is generally considered a benchmark for lending. Most banks and lenders use several types of lending indices including LIBOR (The London Interbank Borrowing Rate), Matched Term Treasuries, SWAP Rates, Bond Rates, etc. And while some banks base their commercial loan and leasing rates on Prime (plus some number, Prime + 1%, 2%, 3% etc) the rate that any given commercial or business customer qualifies for, at any given time is dependent on many factors.

FACTORS EFFECTING BORROWING COSTS:
My list of factors, affecting a customer's borrowing rate, is not all inclusive, but includes: The quality of relationship and trust between the lender and the borrower, the Cost of capital to the lender, the amount to be borrowed, the type of loan, lease or other instrument, the term of the loan or lease, the equipment or asset being financed, the utility and future marketability of the collateral, the degree of col lateralization (how well secured is the lender) the frequency of payments (monthly, quarterly, annually, seasonally) the application or absence of personal guarantees, the time in business of the enterprise, the financials and tax returns of the enterprise, the tangible net worth proportionate to the amount borrowed and the historic and expected cash flow proportionate to the amount borrowed, the inclusion of fees, the availability of blanket liens (on current and future assets), amount and nature of liquidity accounts resting with the lending institution, compensating balances (both as an offset to risk and as a source of revenue to the institution), control via restrictive loan covenants (which may include the requirements for audited financials, certain financial performance factors, management permanency, etc), investment by the borrower in down payments, prepayments, or capital reductions of the amount to finance, whether the loan or lease is structured as a fixed rate or floating rate transaction, the timing of funding vs. the timing of payments (early funding with later payments is more expensive than early payments with later funding). As I said this list is not all-inclusive but gives some idea of the types of factors that may effect borrowing costs, risk assessment, measuring of credit costs, loan amortization, billing-collecting costs, loan administration, etc.

SUMMARY:
From my perspective the bottom line for any client is to gain an understanding of your particular situation and how you and your business might be viewed by your lender or other sources of capital. Develop a relationship with lenders so that they can fully understand your business and can gain trust in you, your management team and your business. Consider your objectives against the lenders own. Seek to work with your lender to negotiate a fair but realistic transaction and relationship based borrowing line. Consider your lender as an investment partner in your business. Build and sustain a financial package and portfolio that explains your company, the market, your competitors, and addresses the potholes, dips and peaks, changes and events effecting your business. Don't ever ever ever mislead or try to "bluff" your lender. In most cases you will lose the very trust you want to engender for your business and yourself. Lastly, remember that interest rates reflect the cost of your use of outside capital as an investment tool to acquire assets to enhance value and build revenue. In most cases the lender's return on capital is somewhere around 1% to 3% which is a relatively small margin compared to just about anything else you might acquire including the equipment, technology and systems being financed.