How Banks Establish Interest Rates on Business Loans

The Prime Interest Rate and LIBOR

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When banks quote an interest rate to small business owners on a proposed bank loan, they typically use a benchmark to calculate that interest rate. Most of the time, that benchmark is the prime interest rate. The prime rate is the interest rate a bank charges its most creditworthy customers. It is the base rate on corporate loans posted by at least 75% of the nation's 30 largest banks. In some cases, depending on the business and the lender, business owners may be offered a rate based on a similar benchmark, The London Interbank Offered Rate, or LIBOR.

The U.S. Prime Rate

The prime interest rate is relevant to small businesses because banks generally use it as the starting interest rate from which to calculate the interest rate to charge on bank loans. The average small business customer can usually count on the bank adding a few percentage points to the current prime rate. In a tight money period, a small business may have to pay an even a higher rate. It is almost unheard of for a small business to be offered a loan at prime.

Fixed vs. Variable

The prime rate varies more than you may think. In February of 1972, for instance, the U.S. Prime Rate stood at 4.5%. It then began a wave-like rise, generally changing either a quarter-point or a half-point monthly. There were periods when if fell back again, but only to a degree. By December 1980 the prime stood at an astonishing 21.5 percent -- its all-time high.

This kind of range and the underlying interest rate volatility it represents can be ruinous for a small business, especially because lenders making shorter term business loans often deny small businesses a fix rate loan, thereby subjecting them to unsustainable interest expense as the prime rate soars.

As a general rule, if a small-business owner can get a fixed rate in a low-interest environment, such as the "quantitative easing" period that followed the 2007 financial meltdown, it sees prudent to do so. While its generally true that the interest rates offered on fixed-rate loans are a point or two higher than a similar loan with a variable rate, accepting the slightly higher fixed-rate product provides certainty and protect the business owner from the chaotic prime-rate situation that prevailed in the interest-rate run-up that culminated in 1980's 21.5 prime.

Keep in mind that small business owners weren't paying 21.5% -- they were generally paying from 1 to 5 points more.

The LIBOR

Another important interest rate is the London Interbank Offered Rate or LIBOR. If your small business is an import/export business or another business with an international presence, then this interest rate may be of importance to you. The LIBOR rate is the overnight  interest rate for the London Eurodollar market for loans. It generally moves right along with the prime rate, although historically it has been slightly lower than the U.S. prime, but also more volatile.