What It Means
A finance company is an organization that makes loans to individuals and businesses. Unlike a bank, a finance company does not receive cash deposits from clients, nor does it provide some other services common to banks, such as checking accounts. Finance companies make a profit from the interest rates (the fees charged for the use of borrowed money) they charge on their loans, which are normally higher than the interest rates that banks charge their clients.
Many finance companies lend to clients who cannot obtain loans from banks because of a poor credit history (the record of an individual’s payments to the institutions who have loaned him money in the past). Such clients secure their loans with finance companies by offering collateral (by pledging to give the company a personal asset, or possession, of equal value to the loan if payment on the loan is not made). In other words if Bob borrowed $5,000 from a finance company to cover the costs of starting a house-painting business, the finance company might ask that he offer his pickup truck as collateral. If Bob were to default (fail to make payments) on the loan, the finance company would take possession of his pickup truck.
Some large companies own finance companies that provide clients with loans to purchase goods from the large company. Under this arrangement the large entity is called the parent company, and the smaller entity is called a subsidiary, or a captive finance company. Each of the leading American automotive manufacturers maintains an affiliation with a captive finance company that finances the loans on the sales of their vehicles. For example, many people who purchase vehicles from General Motors obtain their loans from General Motors Acceptance Corporation (GMAC). The Ford Motor Company owns Ford Motor Credit Company (FMCC), and Daimler Chrysler owns a finance company called Daimler Chrysler Financial Services.
When Did It Begin
General Motors was the first of the Big Three American auto manufacturers to open a captive finance company, establishing branches of GMAC in Detroit, Chicago, New York, San Francisco, and Toronto in 1919. The following year GMAC expanded to Great Britain, and by 1928 they had issued more than four million loans. In 1985 the company earned $1 billion in revenues. That same year GMAC began offering home loans and soon after branched out further by lending to large and small businesses and by selling insurance. After recording earnings of $1.8 billion in 2001, GMAC had financed more than $1 trillion in loans on more than 150 million vehicles since its inception. Ford Motor Credit Company began operations in 1959 and manages approximately $150 billion in loans in 35 countries. Daimler Chrysler Financial Services began operations in 2002.
Such finance companies as Allied Capital and the Money Store, which specialize in lending to small businesses, began operations as far back as the 1950s and 1960s, but these companies experienced major growth in the 1990s, when Americans started borrowing larger sums of money for both personal use and for their small businesses. As lending increased, more people defaulted on loans and filed for bankruptcy, which made banks reluctant to continue lending money, especially to small companies that were unlikely to remain in business. This created a large pool of loan candidates for finance companies. For example, in 1996, 37 percent of the small-business owners in America requested loans from banks, and 25 percent of these were rejected. Companies like Allied Financial began providing loans to these clients at high interest rates.
More Detailed Information
Most economists separate finance companies into three major categories. The first group, known as consumer finance companies, makes small loans to individuals, usually on terms that are unfavorable for the client. These businesses, which are also called direct-loan and payday loan companies, have been accused of taking advantage of people who are in desperate need of cash. A typical relationship between a direct-loan company and a client might go something like the following. The client needs $200 to cover the rest of his monthly expenses, but he has no money left in the bank and his next paycheck is two weeks away. The client goes to the consumer finance company with a personal check, proof of income (an old paycheck stub), and a recent bank statement. The finance company verifies the client’s identity and check to make sure that he is currently employed. Before leaving with the $200 in cash, the client writes a check for $230 and postdates it by two weeks (writes a date on the check that is two weeks later than the date of the current transaction). This check will serve as collateral for the loan. If the customer does not show up to pay the $230 dollars for the $200 loan, the finance company will cash the check. Such a company may also ask for the title the customer’s car to ensure that the customer does not close his checking account and leave the direct loan company with no way of getting value back for the loan. Though the $30 fee for the loan may seem fair given that the client needs the money, this charge amounts to 15 percent interest on a two-week loan, or 390 percent annually. Loans that are offered for interest rates higher than the market average are called subprime loans. Because some direct-loan companies demand even higher rates of interest, many states in the United States have established small-loan laws that cap interest rates on these subprime loans at or around 25 percent.
The second type of finance company is called a sales finance company, or an acceptance company. These agencies make loans to businesses to help those businesses cover short-term costs. Acceptance companies provide a service for businesses that is similar to the service direct-loan companies provide for individuals. There are some important differences, however. First, businesses that conduct transactions with (borrow money from) acceptance companies are large corporations with high credit ratings. Such corporations are not asked to secure their loans with collateral. Second, in these transactions the businesses usually receive interest rates that are the equivalent of, or slightly better than, rates they would receive from a bank. In many cases the terms of the loan stipulate how the business can allocate the borrowed funds (for example, to meet payroll or to purchase inventory). Businesses cannot use these funds to do such things as build a new plant or buy additional real estate. The sums involved in these loans are quite large, often in the millions of dollars.
Commercial finance companies, which are also called commercial credit companies, are the third type of finance company. They make loans to small and large businesses, often to help them cover costs for new equipment. Because they represent a greater risk for the commercial credit company, small businesses often pay higher interest rates than large businesses. The interest rates on these subprime loans tend to be between 0.1 and 0.6 percent higher than prime rate loans, which are the loans given by banks to more financially qualified clients. Though this may seem like a small difference, these percentage points often translate into thousands of extra dollars in revenue for the finance company. The finance companies often need this extra money from their paying customers, however, because they tend to have a greater number of delinquent clients than banks have.
Though banking institutions remain the most popular source of business loans, many Americans seeking loans for small businesses have begun to prefer finance companies to banks because finance companies are less concerned with their prospective clients’ credit history. This means that a finance company is more likely to approve a loan request than a bank and that a finance company will be apt to lend more money for longer periods of time than a bank. Small business owners generally request loans from finance companies to purchase inventory (the goods they sell) from wholesalers (the companies that sell goods to retail stores). In exchange for favorable terms on a loan, finance companies often require small business owners to make their assets available as collateral.
Commercial finance companies grew steadily throughout the 1990s, and by the end of the 1990s they were the second largest provider of business credit in the United States. During the 1990s the Money Store and AT&T Small Business Lending had emerged as the two largest finance companies in the United States. In 1997 the Money Store offered 1,784 loans to small businesses for a total of $784 million. AT&T Small Business Lending offered 1,254 loans for $480.5 million that year. Six U.S. finance companies loaned at least $100 million each to businesses in 1997, and nine more finance companies loaned at least $50 million each.