Whether you’re buying a car or financing a business, the first question most people ask is, “What’s my rate?” It’s always a factor when looking to make a major purchase, and no matter what the rate is, it’s almost never low enough.
So how do banks decide what rate they are going to offer? If you have opened a CD (certificate of deposit) lately and found a bank is paying a whopping 0.50% annual percentage yield, or if you have money in your checking account and you’re earning nothing, you’re probably thinking, “Man, money is cheap!”
Then you ask a bank for a loan to purchase a new building so you can expand your business, and they slide a term sheet across the table that says your rate on the building purchase, for example, is 5.50 percent. Your next thought is probably, “Wait, you’re paying me close to zero on my money and charging me 5.50 percent!” The fact is, there is a lot more that goes into what rate a bank charges than how much a bank is paying on your money.
Rates can vary for many different reasons— the type of loan (line of credit, term loan, commercial mortgage), the length of the loan (one year, five years, ten years), the risk of the loan (how likely is the bank to be paid back), and the borrower’s credit history, to name a few.
It’s also important to know there are two primary categories of loans: consumer and commercial.
- Consumer loans are what most of us are used to seeing—things like cars, personal lines of credit, credit cards or a mortgage to purchase a home. Consumer loan pricing is primarily based on an individual’s credit score, current debt-to-income ratio and type and age of collateral.
- Commercial loans are for small and larger businesses. For example, the needs may vary from a $5,000 equipment loan for a local restaurant to a $10,000,000 mortgage to purchase a new building. Commercial loan pricing is tied mainly to a company’s historic and future profitability, and the five C’s of credit:
Character – What is the repayment history with other creditors? (Notice this is first on the list.)
Capacity – Does the company have the cash flow to service the debt?
Capital – Does the company have sufficient capital?
Collateral – Will the collateral support the debt requested? (Notice this is listed next to last.)
Conditions – What are the conditions of not only the borrower but the overall economy?
As you can see, there are many factors that play a role in determining what your rate will be. The most important thing to remember is maintaining a good credit history is crucial to getting a good rate, or getting a loan, period. If you are looking to borrow money, always walk into the meeting prepared. If it’s a consumer loan, like an automobile purchase, know that your credit score may affect the rate. If it’s a business loan, be prepared by knowing your financials. Have a clean, accurate set of historic, current and projected financials. Always know where you are heading financially. It’s like the saying goes, “If you aim for nothing you will hit it every time.”