Financing Institutions and Their Roles in Corporate Finance
Financing institutions are kind of like banks in that they lend money, but they’re a bit different, too. First of all, they tend to give different types of loans than banks do. Secondly, they get their funding by borrowing it themselves instead of through deposits. They earn a profit by charging you higher interest rates than they’re paying on their own loans.
Sales financing institutions
If you’ve been to a car dealership, furniture store, jewelry store, or some other retailer that deals in expensive merchandise, odds are you’ve been offered a loan that you can use to purchase an item immediately and then pay off the loan in installments.
The store itself isn’t offering you the loan; a type of financing institution called a sales financing institution works with the store to give you the loan. Sales financing institutions work with both individuals and companies making large purchases.
Personal credit institutions
Personal credit institutions are companies that offer small personal loans and credit cards to individuals. Because they don’t have much to do with corporate finance — unless the personal credit institution itself is a corporation or you’re using your personal line of credit to invest in a corporation (in which case, as long as your returns exceed the interest you’re paying, then good for you).
Business credit institutions
Did you know that corporations can get credit cards and credit loans just as you can? Well, they can, and those credit loans come from a type of financing institution called a business credit institution. Business credit loans differ from standard business loans in that they’re a running line of credit in the same way that your credit card is a running line of credit.
These loans can be freely increased or gradually paid off within certain limits as long as the corporation makes periodic minimum payments on the balance.
A special type of business credit institution, called a captive financing company, is a company that’s owned by another organization and that handles the financing and credit only for that organization rather than for any applicants. For example, GMAC, the financing arm of General Motors, which changed its name to Ally Bank, is the captive credit financing company for the corporation General Motors.
Loan sharks and subprime lenders
Prime rate is the interest rate charged to customers who are considered to be of little or no risk of defaulting. In the U.S., the prime rate is about 3 percent above the interest rate that banks charge each other, called the federal funds rate. (Some nations use LIBOR, which is the London Interbank Offered Rate.)
For those corporations and people who are considered higher risk, they will often qualify for only loans considered subprime, which are offered at interest rates higher than the prime rate. Another form of high-interest loan is called the payday loan.
The payday loan basically makes loan sharks legal (organizations that offer loans at rates above the legal level and who often have heavy-handed tactics). The payday loan gives you money for a short period, usually only one to two weeks, and charges several hundred percent in annual percentage rate, in addition to fees and penalties.
Rather than breaking your knees, as the stereotype would have it, these lenders simply annihilate your credit score and financial well-being. As a result, many states have outlawed these lenders.
For a period between the 1980s and 1990s, subprime mortgage lenders were also very common. In fact, they contributed to the 2007 financial collapse, when many commercial banks were venturing into the subprime market with little or inappropriate risk management. Bottom line: Avoid loan sharks and subprime lenders at all costs, or they’ll ruin your finances and the greater economy at large.