1. Money

How Banks Establish Interest Rates on Business Loans

The Prime Interest Rate and LIBOR

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When banks quote an interest rate to small business owners on a bank loan, they typically use a benchmark to calculate that interest rate. Most of the time, that benchmark is the prime interest rate. The prime rate is the interest rate a bank charges its most creditworthy customers. It is the base rate on corporate loans posted by at least 75% of the nation's 30 largest banks.

The prime interest rate is relevant to small businesses because banks use it as the starting interest rate from which to calculate the interest rate to charge on bank loans. The average small business customer can usually add a few percentage points to the current prime rate. In a tight money period, a small business may have to pay even a higher rate.

Another important interest rate is the Londan Interbank Offered Rate or LIBOR. If your small business is an import/export business or another business with an international presence, then this interest rate may be of importance to you. The LIBOR rate is the interest rate for the London Eurodollar market for loans. It generally moves right along with the prime rate.

Most U.S. businesses can look at the prime interest rate as a starting point for determining the stated rate banks will quote on a business loan. The stated interest rate is not actually what the small business will pay. The annual percentage rate, or effective rate, is the interest rate the small business will pay, which takes the compounding of interest into effect.

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