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When banks calculate the interest rate for business loans, they usually integrate a number of simple, easy-to-understand factors and combine them into a single, comprehensible number. The interest rate usually uses the prime rate as a base factor in the calculation. The prime rate is the lowest interest rate that a particular bank will charge its customers, and is given to the most creditworthy borrowers.
Prime is typically described as the rate which banks charge each other for loans. Usually 75% or more of the nation’s top 30 banks will follow the prime rate. It is strongly influenced by the national prime interest rate, which is determined by the Federal Reserve Bank. During recessions or otherwise difficult times, cash will be short. Investments that they keep in the stock market will be down and defaults from riskier borrowers will increase. In these situations, banks will borrow from the Federal Reserve Bank to keep interest rates from skyrocketing, or to keep themselves from going bust. Lower national interest rates tend to lead to a large amount of available credit, which in turn results in a lower interest rate for business loans.
For smaller businesses, the business prime rate is used as a base, and percentage points are added on top of it. Depending on the state of the economy, a larger number of percentage points may be added. Typically the rate for small business loans is 3% to 6% over prime, and there are usually fees that exist in either the form of a small percentage or a nominal amount.
It is important for you to be aware of the mechanisms that determine the interest rate for business loans because it will allow you to identify the deal that you are getting when you hear about a change in the national prime rates. If you notice a shift and done see a commensurate shift in your bank’s refinancing options, it may be time to do some sharp negotiating with them, or plan on using a different bank.