The Prime Rate—and Why the Bank Will Never Offer It to You
The Prime Interest Rate and LIBOR
Banks typically use a benchmark to calculate interest rates they quote to small business owners on proposed bank loans. Most often, that benchmark is the prime interest rate. The prime rate is what banks charge their most creditworthy customers, and it is the base rate on corporate loans posted by at least 75 percent 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 (LIBOR).
The U.S. Prime 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 bank loans. The average small business customer can usually count on banks adding a few percentage points to the current prime rate. In a tight money period, 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 rate.
Fixed vs. Variable
The prime 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.
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 2007 financial meltdown. 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. Keep in mind that small business owners weren't paying 21.5 percent by 1980; they generally were paying from 1 to 5 percentage points more.
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.
Getting the Best Rate
Investopedia recommends looking at your loan from the perspective of the bank. 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. It's also a good idea, the site suggests, to consider taking out loans at times when the market is down. Fewer clients are seeking loans at those times, making banks more amenable to offering favorable rates in order to acquire additional business.