When it comes to loan pricing, there are two facts every owner should know:
1) Not all loans should be tied to Prime.
2) When using prime benchmarks, banks may have different prime rates!
Let’s deal first with the issue of different prime rates. Although most of the top 10 national banks will typically have the same prime rate, many small banks charge prime rates that are higher than the Wall Street Journal prime. To safeguard your loan decisions, always ask the bank to disclose their current prime rate.
You see, the prime rate is set by bank management. Supposedly, it is the rate the bank’s best borrowers can obtain on loans. (That’s what banks say but not what they practice!)
The published prime rate today, however, gives the bank a very large profit. This is because the federal funds rate, which is the rate at which banks can borrow, is very low.
For most borrowers, two alternative benchmarks work well – Internal Cost of Funds Rate and LIBOR. Let’s start with the internal cost of funds.
This benchmark is considerably less than prime and is the federal funds rate plus a small spread to cover administrative costs. Cost of Funds borrowing is usually the best and cheapest method.
Another popular option is LIBOR-based borrowing which is the London Interbank rate. Again, this benchmark is well below prime. It may also be more complex to borrow under LIBOR. Typically, you must borrow in $100,000 increments for terms of 30, 60 or 90 days. Once you borrow for a set period, you may be stuck due to large penalties for early payoff.
LIBOR is also a more volatile rate than prime. For the most part, it is used as a fixed rate benchmark. If you use LIBOR for variable rate instruments, you may be in for a rocky ride and an accounting nightmare!
Other common benchmarks for loan pricing include treasury notes, Fannie Mae rates and other mortgage rates. Before you sign documentation, make sure you understand the advantages and disadvantage of any benchmark offered.
Finally, don’t expect your banker to come to you with creative benchmarks. Most bankers these days have compensation based upon portfolio yields. It is in their personal and professional best interest to get as much from you as they can!
Your best strategy is to simply complain about your rate to your banker and let him know that with your next loan transaction, you would like to see a “Cost of funds” pricing option.
