Insurance agency lenders meet and discuss loans with potential borrowers every day. It’s equally important to lender and borrower that the terms of each loan are fair and consistent across all loans, so lenders are very careful to ensure that terms are defined equitably using standardized processes.
We’re often asked about loan terms, so we thought it would be useful to offer an overview of them, how they’re set, and what impact they have on your loan.
Understanding Loan Terms
To begin with, loan terms are specific features that define how each loan and its repayment are structured. Terms can include any or all of the following:
• The length of time in which the loan must be paid off or refinanced (it can be confusing that this is sometimes referred to as the “loan term” AND it is one “term” of a loan),
• The interest rate you’ll pay,
• Associated penalties or fees (eg: prepayment penalty),
• Any special repayment provisions (eg: an interest-only period),
• Possible other features and contractual obligations (eg: a balloon payment).
This assortment of terms acts as a set of levers for a lender, allowing him/her to build each loan.
While some insurance agency lenders offer broad, one-size-fits all loan products which have set terms, other lenders offer loans whose terms are customized to each borrower.
As a specialty lender, we work closely with each agency owner to create terms that suit their agency’s business goals, financial needs, and credit-worthiness (or the degree of perceived risk in lending to that agency owner).
Interest Rate is the loan term that borrowers tend to focus on
The one loan term that seems to get the most attention when we talk with borrowers about a loan is interest rate. It makes sense, since the interest rate has the most clear and direct bearing on how much you’ll end up paying for your loan. But it’s actually the interplay of all of the loan terms that determines what you’ll pay monthly and, ultimately, over the life of your loan.
Given that we know borrowers want to understand how a lender arrives at a particular interest rate, we offer this brief explanation of the considerations that go into interest rate setting, loan pricing, and the way that all loan terms impact loan repayment.
How a lender determines loan terms
Each lender offers unique terms, but all lenders factor the same set of considerations into their loan pricing and term setting. These considerations include:
1. External conditions, such as the state of the larger economy.
When the economy is strong, it supports the creation of new businesses or the expansion of existing businesses. As a result, there’s a greater demand for business loans and interest rates tend to rise in response to the demand. Conversely, when the economy is sluggish, interest rates tend to be lowered in order to encourage business owners to apply for funds to invest in their businesses. Depending on the state of the economy when you’re looking for a loan, your interest rate may be higher or lower.
Additionally, federal interest rates, industry-specific legislation, and prevailing political conditions exert an influence on the level of risk associated with lending money at any given time, which is reflected in individual lender’s interest rates.
Even though you, as a borrower, cannot influence these factors or control for/against them, they do impact the economic context in which your particular loan is made, so it’s worth being aware of them.
2. The cost that a lender must incur in order to raise the funds being loaned.
This one is pretty simple: It costs money to loan money. The costs associated with a loan will vary depending on the lender, and whether he/she lends their own funds, brokers loans out, or accesses funding from investors, customer deposits, money markets, or other sources. Given this fact, it makes sense for borrowers to shop around and talk to a variety of lenders since the cost to raise and loan funds can vary quite a bit from lender to lender.
3. A risk premium is factored in to compensate the lender for the degree of risk being assumed in loaning money out and counting on it to be repaid.
A lender has to try to assess the risk associated with lending you money. In order to do this, your personal and business credit scores are taken into consideration as an indication of your creditworthiness. A lender will also try to assess you as a borrower, using a mix of the “5 C’s”: Character, Capacity, Condition, Capital, and Collateral. [link to 5Cs blog post].
You’ve probably heard it said that “past performance isn’t indicative of future results.” Well, to be honest, your personal and agency credit histories are the best/only means a lender has to try to predict your future financial behavior (eg: repaying your loan while managing your agency finances and maintaining enough cash flow to operate your business). Overall, borrowers with good credit histories are rewarded for their responsible financial behavior. A borrower with a stronger credit history will get a reduced price on a loan as a reflection of the expected lower risk that the lender is taking on.
The term of your loan, or the length of time you have to repay it, also impacts the risk premium. The shorter the term, the lower the risk, since the ability of a borrower to repay a loan is assumed to be more stable, predictable, and reliable over the next three years than it will be over the coming 15 years. The purpose of your loan can also tie to your repayment term and associated risk. Short-term needs, like working capital, carry less risk than long-term needs, like business expansion, as long as it’s clear that your agency isn’t solely relying on an infusion of short term capital in order to simply survive.
The collateral associated with your loan also affects the risk premium that a lender will charge. The collateral that’s used to secure a loan, decreases the perceived risk of the borrower defaulting on the loan. The more valuable and stable the collateral, the lower the risk and the lower the interest rate charged. It also matters how liquid the collateral is, meaning how easy it is to sell the collateralized asset in order to get back any funds not repaid. For an insurance agency loan, when the collateral is your book of business, it’s assumed that the value of the collateral to you, the borrower, is quite good, thus reducing the risk of you defaulting on your loan. But using your book as collateral rather than an asset like real estate, has some challenges, since there’s no standard set of valuation metrics for a book and there’s a smaller market for resale in the event of a payment default. For those reasons, there can sometimes be a higher premium on the use of a book as collateral.
4. The cost of doing business.
A lender has to cover the costs to service a loan, from application through payment processing and loan monitoring (including overhead and salaries for employees who do this work). It’s also necessary for a lender to make a reasonable profit on each loan, since that is how he/she stays in business. And, of course you want your lender to stay in business so they can continue partnering with you in support of your agency, servicing your current loan and working with you on any future loans you might need.
Customized loans match loan terms to agency goals
While you may see lenders advertise certain interest rates as a major selling point for their loan products, it’s important to remember that other loan terms factor into the design of your loan. Customizing a loan for your agency requires a knowledgeable lender, experienced in insurance agency loans, who can understand your agency and match the right loan terms to your business goals.
Our Lending Advisors are well versed in customizing loan terms and we’re always happy to speak with agency owners about them. If you have questions about a loan to grow your agency, fill out the form below or click the button at the top of each page to book a no-pressure, 30-minute consult with a dedicated Lending Advisor who knows the insurance industry well and can answer all your questions