Why commercial borrowing can cost more

cost of commercial borrowingWhy does commercial finance cost more?

It is a common question as to why some types of commercial borrowing cost more than others, or why a residential mortgage always costs less.

The reason sits a little in risk and a lot more in how banks borrow and how their rules on liquidity work.

Let me explain.

Risk & Price

If a lender ever tells you that the price of the borrowing relates to the level of risk then they are not being 100% true. Whilst it is related to risk it is mainly focused on market and competitive prices.

Let’s say you had a deposit account which had hefty early access penalties so you decide to borrow and use your deposit account as security. The bank has zero risk as they have cash as security to cover the entire borrowing. No risk, but they will still charge interest. If it was all about risk then you could borrow for free.

Using risk as a reason for cost is an easy option but it only serves to mislead or confuse so I will give a little more insight.

Statistical Default

There are two reasons why different types of product carry different interest costs. A borrower could borrow using a loan and an overdraft. The same borrower with the same attributes but two different sets of pricing.

Typically an overdraft costs more than any other type of borrowing. One of the big reasons I will explain shortly. The lesser reason is down to default.

With an overdraft, the first time the lender sees a problem is when the overdraft limit is breached or constantly used to the max. In this event, the whole facility is used, and often a bit more, before the lender picks up the increase in risk. In effect, the lender is the last to know. There is little early warning of a problem and the money is gone.

With a loan the warning sirens go off when a payment is missed, the risk is easier to quantify and picked up much earlier which is why it is generally a preferred option for lenders.

The Real Reason Pricing Differs

The biggest reason is one that lenders are not very good at explaining. Back in 2009 the word ‘liquidity’ was all over the news. It went from being a term rarely heard to a term bandied all over the news.

For a bank, liquidity is about how much capital they have versus how much they have lent.

A bank will take in deposits but they can lend far more than the cash they have sitting in their coffers. It is this ratio that really influences the pricing, it is why commercial borrowing costs more than your home mortgage and why different products cost different amounts even when everything else about the borrower remains the same.

This is where the main difference in cost comes from, it is about how much the bank can lend with the deposits they have. The more they can lend the less they can charge as the cost to them of lending that money reduces.

For example;

  • A bank has £1m in deposits (or capital) that it can use to lend
  • The type of borrowing defines how much capital they need to set aside (liquidity)
  • For a small business overdraft the bank needs to set aside 50% of capital, this means on £1m of capital they can lend £2m in overdraft limits. Not every overdraft is used which means a lot of capital tied up and potentially very little income, so the price of borrowing is high
  • On a standard residential mortgage the bank needs to set aside 5% of capital, this means on £1m of capital they can lend £20m in mortgage loans. Each mortgage earns them interest from day one and offers a far better use of capital, hence the price of residential mortgage loans are low

The figures here are simplified to provide an example. The level of capital required will vary and will increase should the risk become higher (i.e. a client defaults), plus there is far more to the equation. The theory though is correct.

The graph below gives an idea of how £1m of capital can be used across different products and sectors.

Capital lending liquidity Basel

If you can get your head around how this works then it starts to explain why most banks dislike overdrafts and prefer loans. It also starts to explain why commercial mortgages cost more and why large companies seem to be more appealing to lenders than the small business.

I don’t seek to justify but I do believe that giving an insight into why things are as they enable a borrower to gain an understanding. In every negotiation (which lending often is) the more you understand the other party the easier it is to get the deal you want.

For any questions then please get in touch.

By Dave Farmer

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Why does commercial finance cost more?
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Why does commercial finance cost more?
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Why does commercial finance cost more? It is a common question as to why some types of commercial borrowing cost more than others, or why a residential mortgage always costs less. The reason sits a little in risk and a lot more in how banks borrow and how their rules on liquidity work.
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