Three Ways a Low Finance Rate Carries a High Cost

Choosing the lowest rate on equipment financing can sometimes be a mistake for small businesses. Let’s explore why.

Michael Longmire Lhlt M Gdohc8 Unsplash
Michael Longmire on Unsplash.

In the COVID-19 world, both present and future, it has become very clear that financial flexibility, as well as “cash on hand,” is going to be important for small businesses.

This means for solid, good-credit companies, financing equipment will take on a greater significance as they look to keep more of their own money close to home. Makes sense, right?

But there is a hidden pitfall that companies should be aware of – the lowest rate is not always the best deal. In fact, choosing the lowest rate on equipment financing can sometimes be a mistake for small businesses. Let’s explore why.

How are Rates Arrived at Anyway?

First, we need to understand how financing rates are set.

Finance rates derive from the Federal Fund Rate, which is what banks charge each other. This is the rate you often hear about when the Federal Reserve raises or lowers rates. All lenders take it and adjust upwards based on risk.

A lender’s risk is comprised of several factors: the borrower’s credit score, their income/revenue, time in business, etc. Most companies fully understand this part; the better your credit score, revenues, and lending profile, the better the rate.

But those factors are only half of the equation. Many lenders will also include restrictions on businesses as part of the loan because these restrictions further reduce risk. Banks are well-known to use these types of restrictions. In fact, they are present in almost every bank equipment financing contract. And these restrictions are the reason why your local bank will often have the lowest equipment financing rate.

3 Key Restrictions Lenders Use to Lessen Risk  

There are several covenants lenders (again, especially banks) will put into an equipment financing loan contract to alleviate their risk, and some of them are, quite frankly, extremely limiting for a business.

Here are the three most popular restrictions we see (note: these will be present on even a minor equipment loan).

1)     A Blanket Lien

Anytime a bank loans a business money, they will put a blanket lien on the business. This is usually buried in the fine print and business people pay it little mind, but they should because it can really hamper a company’s operating and financial flexibility.

A blanket lien is exactly what it sounds like – it’s a lien on an entire business and all its assets. So everything the business owns (or will own) is subject to the blanket lien.

This can be crippling because a business with a blanket lien on it cannot sell any of its assets without permission. Even a truck or machine they’ve owned outright for years cannot be sold unless the bank says it's OK. This can be a high price to pay for financing a piece of equipment.

Blanket liens are present on almost every equipment loan given by a bank, and it can really hamper a small business.

2)      Requalifying for the Loan Annually

Almost all banks will want a borrower to requalify for the equipment loan annually, and they reserve the right to call in the entire loan at anytime.

This means the numbers need to stay strong next year, and the year after, and so on. Having a bad year is completely off the table. But not only that, this clause can also stifle another large purchase, a merger, or anything similar. A bank calling in an entire loan two, three, or four years early can cripple a business. It could even drive it to bankruptcy. And this clause is explicitly written into almost all bank-funded equipment financing contracts. 

3)      Minimum Balances

Most banks will want a company to keep a certain balance within their bank. Typically, it’s 80% of a loan amount, and this balance may not go lower. Again, this is in the fine print of almost all bank-funded equipment financing contracts

In essence, this means a company has 80% of the loan amount tied up in the bank. Looking at it another way, a company is actually borrowing its own money and paying an interest rate to do so. This sounds almost bizarre, but it’s very real.

It’s entirely possible this may go unnoticed by a company because they usually already have accounts at banks that lend them money. What they don’t know is they cannot go lower than 80% of the loan value, and if they do, refer to what was mentioned in #2: the bank will probably call in the entire loan, and with the blanket lien established in #1, it can get ugly fast.

What Can Be Done?

If your lender has these restrictions, you can always ask for them to be dropped. However, that’s unlikely to work – many lending institutions use these restrictions as standard loan clauses and do not modify them.

Also remember that the restrictions lessen the lender’s risk, which lessens the rate, so if you must have the absolute lowest rate, then you must accept the most restrictions. You can’t have one without the other.

However, if you are willing to accept a competitive interest rate (say the second or third lowest rate), then more possibilities open up to you, especially online. It may be worth searching for an alternative lender if you are interested in maintaining maximum financial flexibility.

If you are a growing business with good credit, there are plenty of lenders that will work with you. But the “rate vs. restrictions” equation is very real, and one you should pay attention to. Your company’s future financial flexibility may depend on it. 

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