Finance companies acquire funds by issuing commercial paper or stocks and bonds or borrowing from banks, and they use the proceeds to make loans (often for small amounts) that are particularly well suited to consumer and business needs. The financial intermediation process of finance companies can be described by saying that they borrow in large amounts but often lend in small amounts—a process quite different from that of banking institutions, which collect deposits in small amounts and then often make large loans.
A key feature of finance companies is that although they lend to many of the same customers that borrow from banks, they are virtually unregulated compared to commercial banks and thrift institutions. States regulate the maximum amount they can loan to individual consumers and the terms of the debt contract, but there are no restrictions on how they pursue branching, the assets they hold, or how they raise their funds. The lack of restrictions enables finance companies in many cases to tailor their loans to customer needs better than banking institutions can.
There are three types of finance companies: sales, consumer, and business.
1. Sales finance companies are owned by a particular retailing or manufacturing company and make loans to consumers to purchase items from that company. Sears Roebuck Acceptance Corporation, for example, finances consumer purchases of goods and services at Sears stores, and General Motors Acceptance Corporation finances purchases of GM cars. Sales finance companies compete directly with banks for consumer loans and are used by consumers because loans can frequently be obtained faster and more conveniently at the location where an item is purchased.
2. Consumer finance companies make loans to consumers to buy particular items such as furniture or home appliances, to make home improvements, or to help refinance small debts. Consumer finance companies are separate corporations (like Household Finance Corporation) or are owned by banks (Citigroup owns Person-to-Person Finance Company, which operates offices nationwide). Typically, these companies make loans to consumers who cannot obtain credit from other sources and charge higher interest rates.
3. Business finance companies provide specialized forms of credit to businesses by making loans and purchasing accounts receivable (bills owed to the firm) at a discount; this provision of credit is called factoring. For example, a dressmaking firm might have outstanding bills (accounts receivable) of $100,000 owed by the retail stores that have bought its dresses. If this firm needs cash to buy 100 new sewing machines, it can sell its accounts receivable for, say, $90,000 to a finance company, which is now entitled to collect the $100,000 owed to the firm. Besides factoring, business finance companies also specialize in leasing equipment (such as railroad cars, jet planes, and computers), which they purchase and then lease to businesses for a set number of years.