In this article we are taking a slight detour to discuss a number of important factors that affect the cost of borrowing on a short-term basis before turning our attention to secured loans. These factors which include â€œstated rates, compensating balances, and commitment fees help determine the â€œeffectiveâ€? rate of interest on short-term borrowing.
The stated (nominal) interest rates on most business loans are determined through negotiation between the borrower and the lender. In some measure, banks try to vary the interest rate charged according to the creditworthiness of the borrower the lower the creditworthiness, the higher the interest rate. Interests rates charged also vary in keeping with money market conditions. One measure that changes with underlying market conditions, for example, is the prime rate. The prime rate is the rate charged on short term business loans to financially sound companies. The rate itself is usually set by large money market banks and is relatively uniform throughout the country.
Although the term prime rate would seem to imply the rate of interest a bank charges its most creditworthy customers, this has not been the recent practice. With banks becoming more competitive for corporate customers and facing extreme competition from the commercial paper market, the well establishment, financially sound company often is able to borrow at a rate of interest below prime. The rate charged is based on the bankâ€™s marginal cost of funds, as typically reflected by the London inter-bank offered rate (LIBOR), or the rate paid on money market certification of deposit. An interest rate margin is added to the cost of funds, and this sum becomes the rate charged the customer. This rate is changed daily with changes in money market rates. The margin over the cost of funds depends on competitive conditions on the relative bargaining power of the borrower, but it will usually be in excess of 1%.
Other borrowers will pay either the prime rate or a rate above prime, the bankâ€™s pricing of the loan being stated relative to the prime rate. Thus, the prime often serves as a benchmark rate. For example, with â€œprime plusâ€? pricing a bank might extend a line of credit to a company at the prime rate plus 5% — â€œprime plus 5â€?. If the prime rate is 10%, the borrower is charged an interest rate of 10.5%.If the prime rate changes to 8%, the borrower will pay 8.5%. Among various bank customers, interest-rate differentials from prime supposedly should reflect in creditworthiness.
Other factors, however, also influence the differential. Among them are the cash balances maintained and other business the borrower has with a bank (such as trust business) Also, the cost of servicing a loan is a factor determining the differential from prime. Certain collateralized loans are costly to administer, and this cost must be passed on to the borrower, either in the form of the interest rate charged or in a special fee.
Thus, the interest rate charged on a short term loan will depend on the prevailing cost of funds to banks, the existing benchmark rate (often the prime rate), the creditworthiness of the borrower, the present and prospective relationships of the borrower with the bank, and sometimes other considerations as well. In addition, because of the fixed costs involved in credit investigation and in the processing of a loan, we would expect the interest rate on small loans to be higher than the rate on large loans.