Understanding Small Business Loan Interest Rates

Overview of Interest Rates

During the last 12 months, I have repeatedly heard the terms, ZIRP, Fed Funds Rate, and Discount Rate.  Determined to learn more about economics, and hence these terms, I purchased a book on Macroeconomics and began learning about the impact these terms have on the broader economy and small business loans.

The Fed Funds Rate and the Discount Rate are interest rates which are under the control of the Federal Reserve Bank.   They are instruments of monetary policy designed to provide the Federal Reserve with control over the supply of money in the economy.   The Discount Rate is the interest rate the Federal Reserve charges a commercial bank when the banks needs to borrow money to meet immediate demands for capital.  The Federal Funds Rate is the rate that banks are allowed to charge one another on overnight loans to meet reserve ratio requirements.   ZIRP, or Zero-Interest-Rate Policy, is when the Federal Reserve effectively sets the Discount Rate to 0%.

Commercial Banking 101

Lets put this in the context of a commericial banks, henceforth refered to as depository institutions.  Depositary Institutions are institutions that hold the capital of a business or individual.  Bank of America is a despository institution because any business or individual can deposit money in a savings account.  Depository Institutions don’t sit on your business capital or personal savings, they lend it out in the form or loans at or above the prime rate (we’ll get to the prime rate).

At the most fundamental level, that’s how a depository institution makes money.  If the bank provides you with a 1% interest rate on your deposits, it is most certainly loaning your money out to other businesses or individuals at a higher interest rate.  The interest rate spread is the difference between these two rates.  And while a 2% spread may not seem like much, in aggregate is adds up to a quite a bit.   If the depositary institution is holding $500,000,000,000 in deposits, under current reserve ratio requirements, it can loan out $450,000,000,000.  That’s right, the bank doesn’t need to hold your money, it can loan up to 90% of it out.   A 2% annual spread on $450 billion is a staggering $9 billion annually.  As long as a bank can, net of loan losses achieve a positive spread, it is making money.  The more leverage, the more more it makes.  Damn it feels good be a banksta’…

Fed Funds Rate, Discount Rate, and Business Loans

Banks typically do not borrow from the Discount Rate unless they are, as they are right now, under distress or when it is unable to obtain funds from other banks to meet its reserve ratio requirements.   You have to admit that in the absence of distress, it is a nice feature.  If the bank can lend to businesses or individuals at a rate that is higher than the Discount Rate, then they have a positive spread.   Just keep borrowing, make loans, and watch the money roll in.  This only works if you assume the individual making the loan is credit worthy.  How does this impact business loans?  Its pretty simple.  As the discount rate increases, so too does the rate on business loans.  Remember, its all about using other people’s money to achieve positive spread.

Recall that the Federal Funds Rate is the rate banks charge each other on overnight loans to meet capital reserve requirements.  If Bank A is unable to fulfill its reserve ratio at the end of the day, it must borrow from Bank B, a bank that has capital in excess of its reserve requirement.  By Fed exercises control of the money supply by manipulating this rate.  For example, when the Federal Reserve lowers the Federal Funds Rate, it signals to the market that it will buy bonds and other financial instruments directly from banks.   Buying these instruments from banks provides the banks with capital.  That transaction provides banks with capital in excess of their reserve requirements which, in aggregate, lowers the Fed Funds Rate.  And since its all about positive spread, the bank now has more capital it can loan.

The more money there is in the system, the lower the interest rate:  the supply of money exceeds its demand so  interest rates, or the price paid to borrow falls, across a wide variety of loans, including, business loans fall.   The benchmark interest rate used by banks is the prime rate.  While The Federal Funds rate and Prime Rate are not directly related, they do track each other.  A lower Federal Funds rate typically results in a lower Prime Rate.  And hey, what’s not to like about that!  Just like a bank, a business needs to make a positive spread.  If the Prime Rate is 5% and, as a small business owner, you can get a return of 6% net of operating expenses, that’s great.  If the Prime Rate falls to 4% and you’re still making 6%, even better right?

Current Interest Rates

Determining the current interest rates is pretty easy these days.  You can find it in the Wall Street Journal, or online from sites such as Bankrate.com.  Interest rates for this week, according to Bankrate. com are as follows:

• Federal Funds Rate: 0.50%
• Discount Rate: 0.25%, 0.0% - 0.25% target rate
• Prime Rate:  3.25%

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