Loan Interest Rates for Dummies (and the Rest of Us)

December 11, 2018

Man in suit with graph showing loan interest rates

We spend a lot of time talking about interest rates because they affect so much of our lives.  On a personal level, they govern the cost of our mortgage, our credit card bill and our car payment.  In business, they affect our ability to grow and expand, to invest in new equipment, and to purchase commercial real estate.

But how well do we really understand interest rates?  Where do they come from?  What do they mean, and how can we make smart financial decisions based on our expectations for future interest rates?

Those are questions we’d absolutely love to answer.

Rates From “the Fed”

An awful lot of talk around interest rates centers on “the Fed.” The Federal Reserve is the United States’ central banking system.  Broadly, its job is to make sure that our economy is healthy and as predictable as possible.

When it comes to interest rates, the federal funds rate is the granddaddy of them all.  Every other meaningful interest rate in this country, from your credit card APR to mortgages to SBA 504 loan rates, is either directly or indirectly linked back to the federal funds rate.

The fed funds rate is set, or more accurately targeted, by the Federal Open Market Committee.  They meet about every six weeks and release a target interest rate, often alongside their expected plans for future interest rate changes.

At its core, the fed funds rate is the percentage rate which big banks will lend money overnight to other big banks. To make their target rate a reality, they use a couple of mechanisms: buying and selling government securities (something that happens all the time), as well as changing the amount of money banks are required to hold in reserve (something that happens much less frequently).

For all intents and purposes, the target federal funds rate is the actual federal funds rate.

What’s a “normal” federal funds rate?  That depends.   In a healthy economy, it’s typically going to be between 2% and 5%. Currently, it’s just above 2%.  Its high mark was 20% in January of 1981.  Its low point was in December of 2008, when it hit 0.25%.

Graph showing Effective Federal Funds Rate from 1955 to 2018

Prime Rate – The Basis for Variable-Rate Loans

The prime rate is, at its simplest, the interest rate that banks will give their very best corporate customers.  Each bank technically has its own prime rate, but when people talk about the prime rate, they’re most often referring to the WSJ prime rate.

This rate comes from The Wall Street Journal sending a survey to the 10 largest banks in the U.S., and asking them what rate they’d lend money to their most qualified corporate customers.

Now, while the prime rate is not linked in any official capacity to the fed rate, it’s almost always about 3% higher than the fed funds rate.

In fact, here’s a graph of the prime rate and the fed funds rate over the last six decades.  As you can see, they pretty much move together.

Graph showing Effective Federal Funds Rate and Bank Prime Loan Rate from 1950 to 2018

The prime rate is a very popular tool in managing variable-interest-rate loans.  Credit card debt is typically set at Prime + a fixed percentage.  For example, in November of 2018, the average credit card APR was 17.14%, while the WSJ prime rate was 5.25%, making the average credit card rate about Prime + 12%.

But it’s not just credit card rates that come from Prime. Many other variable-interest-rate products are set at Prime +, including SBA 7(a) loans.

What About LIBOR?

LIBOR is basically the international version of the federal funds rate.  It’s based on eurodollars, traded between banks on the London interbank market.

Just like prime rates, while there’s no official link between it and the federal funds rate, they tend to track each other very closely, with the exception of times when the Fed is taking exceptional actions, e.g., a financial crisis in the U.S. market.

Here’s a chart showing Prime, LIBOR and the fed funds rate from 1985 until 2018.  As you can see, with the exception of the financial crisis of 2008, they stayed essentially in sync.

Graph showing Effective Federal Funds Rate, Bank Prime Loan Rate, and London Interbank Offered Rate from 1984 to 2018

LIBOR is used very similarly to prime rates, in that many variable-rate loan products are pegged at LIBOR + a specific number of percentage points.

SBA Peg and Max 504 Third-Party Interest Rates

Before we drill down into exactly how SBA interest rates are set, there are two more rates to be aware of.  Both of these are set directly by the Small Business Administration, on a quarterly basis.

The first is an SBA peg rate.  SBA 7(a) lenders have the options of tying the loans they issue to either Prime, LIBOR or the SBA peg rate, which also closely follows these indexes.

The Max 504 third-party rate is the maximum interest rate a SBA 504 private lender is allowed to charge for their portion of an SBA 504 loan.  This is typically set as a Prime+ rate, and as of September 2018, was set at Prime + 4%.

Every quarter, the SBA releases these numbers in a press release, and they’re either directly (in the case of the Max 504 rate) or indirectly (in the case of the peg rate) tied to other key rates like the Prime, Fed and LIBOR rates.

Swap Rates & Treasury Yields

We promise these are the last two rates we’ll discuss, but discuss them we must because they’re important for fixed-interest-rate commercial loans, like SBA 504 loans.

These rates are Treasury yields and swap rates. Functionally, they represent the same thing: rates at which large institutions are willing to lend money for a fixed time period, at a fixed interest rate.

Treasury yields are based on the amount the government pays to borrow money for a specific amount of time, say 5, 10, 20 or 30 years.

Swap rates are the rates at which institutional lenders are willing to exchange a variable interest rate for a fixed rate over a specific period.  Again, like Treasury yields, in intervals of 5, 10, 20 or 30 years.

Swap rates and Treasury yields tend to be closely linked to each other, and to the other key rates we’ve been discussing, as illustrated in this chart of five-year swap rates, Treasury yields and the federal funds rate.

Graph showing Effective Federal Funds Rate, 5-year swap rate, and 5-year treasury maturity rate from 2000 to 2018

(Note that the Federal Reserve stopped tracking swap rates at the end of 2016, with the reasoning that “given the alternative sources available to the public, the costs of collecting and publishing these data outweigh the benefits,” so institutions like Liberty that use swap rates for fixed-rate loans get them directly from the Intercontinental Exchange.)

How Individual Loans Are Priced

The pricing of nearly all loans follows a pretty simple formula:

(Base Interest Rate) + (Interest Rate Spread) = Loan Interest Rate

The interest rate spread attempts to take into account how risky the loan is, along with other market forces like competition and the necessary profit margin for the lending institution to issue the loan.

SBA loans tend to have an advantage here.  The protections offered by the Small Business Administration to lenders lower the overall risk they take on. As a result, they tend to be at a lower rate than other types of loans that small businesses have access to.

What Makes Interest Rates Rise and Fall?

That’s a very big, complex question that economists could probably argue over for an eternity.  But let’s look at it through the simplified lens of monetary policy at the Federal Reserve. If you think of our economy as a car, the Federal Reserve tries to use interest rates as either a gas pedal or brake to keep us going close to the speed limit.

If the economy is going to slowly, like it was after the crash of 2008, the Fed might hit the gas pedal by lowering interest rates.  This makes it cheaper for businesses to borrow money, and encourages economic activity and investment.

If the economy is going too quickly, and headed toward a possible crash, the Fed might hit the brake pedal by raising interest rates.  As it gets more expensive for businesses to borrow money, things might slow down a bit to a more sustainable level.

The Advantages of Fixed-Interest-Rate Loans in a Rising-Rate Environment

We recognize we’re a bit biased here, but let us make the case for a fixed-interest-rate loan like the SBA 504.

Right now, our economy is doing well, and the Fed has indicated repeatedly that they’re in the process of raising rates.  Barring an economic event that’s unforeseen by Wall Street or the Fed, interest rates are going to be headed up from here.

That means that the sooner you get into a fixed-interest-rate loan product, the bigger your likely savings are to be.

If you get into an SBA 504 loan today, your interest rate is going to be fixed for at least the next five years, as, in all likelihood, rates rise.  With a variable-rate SBA 7(a) loan, as interest rates rise, so will your monthly payments.

The truth is, if you’re eligible for an SBA 504 loan, it’s often the better of the two.  SBA 504 loans are nearly always available at lower interest rates, and have longer-term fixed rates.

Here’s a table that compares average interest rates of SBA 7(a) loans of at least $1M, and a term of 20+ years, with average interest rates for the CDC portion of SBA 504 loans during the same time period.

Graph: Average SBA 7(a) and SBA 504 Rates

Now, if you got an SBA 7(a) loan in 2016 at 5.25%, it would be likely resetting at 6.3% this year.  If you got an SBA 504 loan at 4.3% in the same year, that CDC portion of the loan would be fixed for the 20-year life of your loan.

Let’s look at it another way.  If you borrowed $1 million today, going with an SBA 504 loan instead of a 7(a) would save you about $937 per month in interest, or $11,244 per year.  If rates continue to rise as most people expect them to, that difference would only get more significant over time.

Loan Amount Rate Monthly Interest + Fees Annual Interest + Fees
SBA 7(a) $1M 7.25% $7,228 $86,737
SBA 504 $1M 5.75% $6,291 $75,493
Savings: $937 $11,244

Putting It to Use

Now that you understand the basics of interest rates and loan pricing, you can put that knowledge to use for your customers or your business.

If you’re a broker or business owner, and you agree with the Federal Reserve and Wall Street that interest rates are going up for the foreseeable future, protect your clients or yourself with a fixed-interest SBA 504 loan.

And, as always, we’d be more than happy to help.