Leasing vs. Bank Loans

Banks charge lower interest rates than leasing companies, don’t they? Well, not exactly. That’s because rate per se, the cost per thousand dollars of equipment per month or the "interest rate" that is being factored into the transaction, is an unimportant consideration. Far more important are the terms and conditions of the transaction.

The terms of you "low rate" bank loan usually require that you keep some money, perhaps 20% to 30% of the loan amount in a non-interest bearing account at that bank as "compensating balances" (so the bank is really lending you 70 cents of their money and 30 cents of your own money for each loan dollar). When you compute the real yield on that, you find that a five year 8% loan with a 30% compensating balance requirement is really about a 24% loan (because you’re paying interest on 100%, but only getting 70%). Using the same formula, a 20% compensating balance requirement makes their yield on that 8% loan almost 18% and with a mere 10% compensating balance, it's still about 12.5%.

So you have this “low” bank rate, but you have to leave part of the money in the bank. You also have covenants that require you to maintain certain financial ratios, the bank has filed a blanket lien against your assets and you are cross collateralized with your personal accounts, your kids’ trust accounts and everything else. There is probably a clause in the loan agreement that says that if at any time the bank feels uncomfortable with your industry they can call the loan even if you have made every payment on time, and another that says they can increase their rate if their cost of money goes up. Oh, and they probably didn't want to finance the entire cost, preferring that you made a down payment. In short, there are terms and conditions that you probably didn't know about and a rate effectively higher than you imagined. So it is pretty clear that the “rate” is not the only factor in making a decision on how to finance equipment. You have to look a lot deeper.