The Prime Interest Rate: How It Affects Your Small Business Loan
How do banks establish interest rates?
When you apply for a small business loan, banks typically use a benchmark to calculate the interest rate they quote on the proposed bank loan. That benchmark is usually the prime interest rate. The prime interest rate is what banks charge their most creditworthy customers, and it is the base rate on corporate loans posted by a majority of the nation's 25 largest banks. In the case of adjustable rate mortgages (ARMs) and other variable rate loans, business owners may be offered a rate based on a similar benchmark, the London Interbank Offered Rate (LIBOR). LIBOR may be discontinued sometime after 2021.
The U.S. Prime Interest Rate
The prime interest rate is relevant to small businesses because banks generally use it as the starting point from which to calculate the interest rate to charge on small business loans. The average small business customer can usually count on banks adding a few percentage points to the current prime rate. In a recession, small businesses may have to pay even higher rates. It is almost unheard of for a small business to be offered a loan at the prime interest rate. Most small businesses will be offered an interest rate based on the prime interest rate plus additional percentage points reflecting their own individual risk factors.
Most small businesses will be offered an interest rate based on the prime interest rate plus additional percentage points reflecting their own individual risk factors.
Fixed vs. Variable Interest Rates on Small Business Loans
The prime interest rate has fluctuated significantly over time. In February 1972, for instance, the U.S. prime rate stood at 4.5 percent. It then began a wave-like rise, generally changing either a quarter-point or a half-point monthly. There were periods when it fell back again, but only to a degree. By December 1980 the prime rate stood at an astonishing 21.5 percent—an all-time high. In comparison, the U.S. prime interest rate was 3.25% in April 2020.
This kind of range and the underlying interest rate volatility it represents can be ruinous for small businesses, especially because lenders making shorter-term business loans often deny small businesses a fixed-rate loan, potentially subjecting them to unsustainable interest expenses if the prime rate soars. As a general rule, it is prudent for small business owners to get a fixed rate in a low-interest environment, such as the "quantitative easing" period that followed the 2008-09 Great Recession. While interest rates on fixed-rate loans typically are a point or two higher than a similar loan with a variable rate, accepting the slightly higher fixed rate provides certainty and protects business owners from the kind of rising rates seen in the 1970s.
The LIBOR Benchmark
LIBOR is a benchmark used to set interest rates that are based on market conditions. It is used primarily for residential mortgage loans with variable, or adjustable rates. Historically, LIBOR has also been used for home equity lines of credit (HELOC), student loans, credit cards, and automobile loans.
Small businesses involved in imports/exports or other international operations may deal with the LIBOR interest rate. This 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 and more volatile than the U.S. prime rate.
LIBOR will not be used after 2021 and a commission is looking at alternatives. A definitive alternative has not yet been identified.
Getting the Best Rate
A small business should first apply to the bank with which they do business They're more likely to give a favorable rate to a longtime customer with multiple accounts than to someone they've done little or no business with in the past. Before you apply to the bank, put together a professional presentation concerning why you need the small business loan. Include as many years of financial statements for your business as you have, up to five years.
Before you apply to the bank, put together a professional presentation concerning why you need the small business loan. Include as many years of financial statements for your business as you have, up to five years.
You should include the balance sheets, income statements, and statements of cash flows.
In advance of your presentation to the bank, check with other banks concerning their interest rates on small business loans, along with their other terms. This will give you some negotiating power. Do other banks make loans to businesses similar to yours?
Check your credit score and credit report. Fix any errors on your credit report prior to applying for the small business loan.
Be prepared to pay several percentage points in interest above either the prime rate or LIBOR.
Board of Governors of the Federal Reserve System. "What Is the Prime Rate, and How Does the Federal Reserve Set the Prime Rate?" Accessed April 16, 2020.
The Federal Reserve. "Selected Interest Rates - Daily." Accessed April 17, 2020.
Consumer Financial Protection Bureau. "You Might Have Heard That LIBOR Is Going Away." Accessed April 16, 2020.