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A Primer on Interest Rates

You may know something about the "Prime Rate," but you may not be aware of the other types of rates, fixed and floating, that are available in the marketplace. What follows is a basic primer on the subject.

Floating Rates
There are many different types of "floating" interest rates that your bank may offer. Some of the more common are those that adjust with ...
  • Prime Rate - Most banks follow the lead of the major money center banks in setting their own prime rates. Unless your loan agreement specifies "New York Prime," however, your bank's prime rate may be different from the prime announced by such money center banks. Furthermore, the increases or decreases in your rate may lag the market leaders by a day, a weekend or even longer. Most banks define their prime rate as "the rate of interest established by the bank from time to time whether or not such rate shall be otherwise published." Your loan agreement also specifies when your rate changes after prime changes. It is usually immediately, but sometimes not until the 1st of the next month. (For a history of Prime Rate changes, click here.)
  • LIBOR - This is the acronym for the London Interbank Offering Rate. It is published daily in the Wall Street Journal and other publications and represents the rate of interest that the most creditworthy international banks dealing in the London market charge each other for large loans in U.S. dollars. LIBOR is used commonly as a base for adjusting interest rates on loans for larger companies borrowing large amounts, so it may not be an available option for small to medium sized businesses at your bank. As a rough measure, LIBOR averages about 2% below prime. This doesn't mean that your rate will be below prime if this option is used, since that will depend upon the increment you are charged above LIBOR.
  • CD Rates - Some banks provide for rates to float with 30, 60 or 90 day certificate of deposit rates in effect at their bank or in the secondary market.
  • Treasury Constant Maturity - The Federal Reserve publishes a statistical release, H.15 (519), each week showing yield on actively traded Treasury obligations "adjusted to constant maturities" (the yield for 10 year maturities, for example, will be interpolated from yields on bonds maturing before and after a ten year maturity date). The yields are quoted on various maturities ranging from one to thirty years. The one year maturity yield is used by most banks to set the interest rate on adjustable rate residential mortgage loans, but many banks also use this index for adjusting business loan rates every year. Longer constant maturity yields are used to fix loan rates for longer terms. (For the Federal Reserve's listing of current rates, click here.)
  • "Swap" Rates - These rates are also published in the Federal Reserve's statistical release H.15 (519), and are becoming a key baseline index for many financing transactions. Swap rates are derived from interest rates set in the derivative contracts or "swaps" that trade every day in a $50 trillion international market. Although a swap can take many complex forms, the transaction is fundamentally an agreement between two parties to exchange short-term interest payments for long-term interest payments, or vice versa. Through a broker, each party agrees to assume the interest rate payments of the other's loan, based upon the particular party's desire to hedge their interest rate risk. The fixed rate (from one to thirty years) that the floating rate borrower has assumed is his "swap rate", and the Federal Reserve publishes average swap rates for appropriate fixed term periods. Because the parties involved in such swaps are high-grade corporate and municipal entities, swap rates represent an active and liquid schedule of rates between highly creditworthy institutions. (For the Federal Reserve's listing of current rates, click here.)
  • "Cost of Money." Some banks adjust their rates according to their own cost of money, which may or may not reflect a specific market rate. The problem here is that the rates are not published and cannot be verified independently by the borrower.
Fixed Rates
Most banks will not fix their interest rates for longer than five to seven years, although some will fix a rate up to 15 years. The reason for this reluctance is that, unless the bank "match funds" (locks in a rate on a certificate of deposit or other liability for the same amount and term), the bank is taking the risk that its cost of funds may increase significantly above the quoted fixed rate on the loan. Banks determine the fixed rates they are willing to offer on loans by looking at alternative investments in the market for like terms (adjusted for credit risk), the bank's own cost of funds and management's crystal ball for interest rates.

Get The Best Of Both Worlds
One way to have the best of both worlds is to have a floating rate that cannot exceed a "ceiling" (maximum rate). When this alternative is used, it generally includes a floor (minimum rate) and involves a fee for the privilege.

Other Points Of Interest
There are other things you should know about interest rates in your loan agreement.

Payment Credit Date - A bank may credit the payment of your interest on (a) the actual date that check for payment is received, or (b) a day or so after the check is received to allow for collection of funds, or (c) the due date, if paid within a certain grace period. The latter method is generally found in installment loans, where the payment is the same each month.

Default Rate - Most corporate loan agreements provide for a penalty rate of interest if the loan goes into default. This generally runs from 3% to 5% above the stated interest rate.

Late Payment - If a payment of principal or interest is made after the due date, and after a grace period, if specified in the loan agreement, a fee of 5% to 6% of the late payment may be charged on the missed payment.

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