How does an item's collateral value affect financing interest rates?

George Messic – National Accounts, Crest Capital - 01/03/2011

One of the more interesting aspects of credit and/or financing is how different "types" of financing have wildly different interest rates. For example, mortgages are generally lower than vehicle loans which are both MUCH lower than most credit card rates. But why is that? Why such a disparity? Generally, there are several criterion used to determine an interest rate, including the cost of providing the loan, competition rates, the credit score of the borrower, and what the collateral aspect of the item being purchased is. This last criterion – the collateral value of the item purchased – is generally the biggest culprit for the disparity between interest rates in things like mortgages and credit cards. Let's explore this a bit closer: Part of the cost of offering a loan is the overall risk a lending institution must accept. Not just in a credit score aspect, but also by how much selling a repossessed item will yield in the case of default. Makes sense, right? If the lender can take back the item and sell it for a decent amount, it's not as big a risk as repossessing a worthless (or non-existent) item. This is why homes and real estate generally carry strong (read low) interest rates. Despite recent years, homes are still generally seen as a fairly safe, stable investment, and, in most cases, even appreciate over time. So if a lending institution loans someone money for a home, the home itself carries (and holds) enough value that if the borrower were to default, the home could be foreclosed, and sold for a solid amount. Yes, the lending institution may not get back every single penny (in fact, in many cases, they won't), but they will almost certainly get back enough to make it a reasonable risk. Hence, a lower interest rate. Things you can't resell Credit cards, on the other hand, have almost zero "repossession value". This is because almost all tangible items purchased with a credit card have little to no resale value (it's not like the credit card company is going to come over, take your TV and your shoes, and resell them.) Also, with credit cards, there's sometimes nothing to repossess. For example, a credit card issuer can't repossess a vacation, or last night's dinner, can they (and would they even want to?) Thus, when someone defaults on credit cards, it's almost always a total loss to the card issuer, because there's "nothing" to go after. All items have repossession value This "repossession value" aspect is present for almost any item, whether that value is good or bad. Automobiles have a "good but not great" resale value, hence their rates are in between credit cards and homes (and a lot closer to homes.) Someone's television or shoes have none at all (despite what some shoes cost!) Obviously, homes have a very high repossession value (although current McMansions might sell for far less than people "thought" they were worth…. Ever try to heat 3,500 sq feet? It's expensive.) Business equipment is usually around the automobile level, as most business equipment can be repossessed and resold if needed. However, equipment financing companies have to be wary of tech obsolescence when financing equipment – it does no good to repossess a bunch of four-year-old computers, does it? And does anyone really want that fax machine back? But it's not just resale value: There are a few other portions of an item's value besides straight resale value. One other such aspect is the value the item in question has to the borrower. To give an example here, suppose you don't have enough money to pay all of your bills this month… you can pay some, but not all. Which ones will you pay first? Most people will have a "payment order" that reads something like: Home / Food / Utilities / Car / Cell Phones / Cable / Other Stuff / Credit Cards (although cable might be higher on the list depending on the channels. Personally, we're not giving up the football package). Real estate lenders know this order is pretty common – when funds are low, the mortgage is usually still going to get paid first. Same with automobile lenders – with transportation being a "must have" for most families, they know they are likely getting paid as well. But credit cards? Goodness, they are waaaay down on the list. And the credit card companies are well aware of this – they know they are right below "dog food" in the pecking order. Hence the rates they charge. This also affects other types of lending, like business equipment financing. The more a company "needs" a particular machine, the more likely they are to keep paying on their equipment lease. Thus, equipment financing companies are usually more willing to finance / give better terms on equipment that is tied to production and/or producing revenue. To give an example here, an equipment leasing company might be happy to finance both cafeteria equipment and production equipment, but they may give a slightly better rate on the machine that actually makes the widgets the company sells. That's because they know the company cannot do without it (whereas cafeteria equipment can technically be replaced by a vending machine and a memo that tells everyone to brown bag it!) Ok, we can sell it… But who's buying? There's one final portion of this whole "can we repossess and resell it?" question. And that's just how easy something is to resell? Again, in the case of real estate and automobiles, there are favorable conditions, as both have strong, vibrant resale markets with plenty of eager buyers (ever go to an automobile auction? It's like the mosh pit at a Metallica concert). But other "hard" equipment (otherwise known as "hard collateral")? It may not be as simple to unload. For example, an envelope folding machine is repossessed – quick, how many envelope manufacturers are in your town? Ok, your county? Your state? The answer might be zero across the board. That's not a Metallica concert – that's a (bad) poetry reading. Wrapping it up All of the above combine to help shape the finance rate of an item. The general rule is the more an item is worth (both in dollars and to the borrower), and the easier it is to resell to an eager market, the better the rate will be. Crest Capital is an Equipment Finance and Equipment Leasing Lender that provides businesses with the funds they require to obtain the equipment they need. Regardless of the strength of the economy or the current economic climate, Crest understands that solid businesses still wish to grow, and strives to provide easy financing at great rates, with the fastest approval time in the industry.