Having been open for nearly three years, Home Improvement Lending has established some relationships with notable contractors. Frankly, as a new name in home improvement lending, we probably wouldn’t have made a dent in the market if the economy weren’t in a bit of flux at the time. Sometimes you just get lucky.

With bigger relationships, we sometimes exchange customization for a volume commitment. In one of these negotiations, the issue of interest rate risk came up. Of course, the contractor doesn’t think of it as interest rate risk. From their perspective, they simply want advance notice of pricing changes. As a non-banker, this is an eminently reasonable request. If prices are going to change, give a few weeks notice so that budgets can be adjusted and profit margins can be maintained.

We like that kind of thinking. Contractors who think like that are contractors who will find our program attractive. But this is a double-edged sword; advance notice of pricing changes creates interest rate risk for us. Banks operate with much smaller margins than many industries, including the contracting industry. As financial intermediaries, we take deposits and aggregate them in order to make loans. Those deposits cost us money every day and we generate interest income from the loans to cover that cost plus our expenses. At the end of the day, a bank performing reasonably well will produce a return on those loan assets of around 1.5%.

Imagine that market rates are rising. If tomorrow, the Fed raises rates by 1.5% and we are constrained contractually to not change our loan pricing, what happens? The deposits we get increase in cost by 1.5 percentage points and our loan interest rate doesn’t change. We make no money on those loans. That’s interest rate risk illustrated (actually, this is an oversimplification of the issue, but the end result is similar) and why we avoid it like the plague.

It still looks like we may see rate increases start again in 2015, so all of us should be preparing mentally for a return to the “old” normal. It’s sure been a long time!