Making Sense Of Interest Rates

Making Sense of Interest Rates

Business borrowers are watching closely as official interest rates rise across the board.

So what does this mean for your business and why do rates vary between commercial rates, home loan rates and equipment finance rates?

Business loans and home loans are typically structured with variable interest rates and not as fixed interest rate loans. This means that the amount you pay today can be significantly different to what you will pay if rates change in the future.

Home loan rates are usually lower than business loan rates because they are fully secured by real estate property and, as most home loans are only up to 70% of the property value, there is minimal risk to the financier.

Conversely commercial loans are not always fully backed by real estate property and place reliance on the performance of the business. As such, there is a greater risk to the financier and rates are therefore often higher than home loan rates.

Equipment finance, through leases, hire purchase, rental or chattel mortgages, is a very different arrangement. The repayments are based on fixed repayments over a fixed term, so a five-year hire purchase will mean that the financier needs to factor in interest rate movements over the period of the loan. In the current environment, expectation are that rates will increase during that time.

The other consideration is that unlike home loans, where they typically will only lend up to 70-80% of the property value, equipment is typically financed at 100% of its value. As such, the interest rates are higher on the basis of higher risk.

The Global Financial Crisis (GFC) has had the added effect of increasing the bare cost of funds to the financiers.

Financiers get part of their money from cash deposits and part from the wholesale markets around the world. The wholesale markets have become less plentiful over the last year and the options available are demanding for higher margins to compensate for these perceived higher risks.

The fall-out from the GFC has also meant that there are now significantly fewer financiers in the market than there were a year ago. Those who remain are being much more selective in how they lend their limited funds and are demanding a much higher return. Of course, less competition means higher prices.

So whilst the cash rates released by the Reserve Bank are significantly lower than pre-GFC levels, this is only reflected in the short-term rates and not in the longer-term commercial or equipment rates.

Which option is best for you? It's important not to use just one form of finance or just one financier. It is very much in your business' best interest to separate as much as you can your home loan from your business and equipment finance.

(Article by Andrew Sutherland (Interlease))