Prime-based loans may not be your best alternative given today’s interest rate environment. Why? The prime rate is actually quite high compared to other rates available in the marketplace.
First, let’s talk about what Prime is and is not. A prime rate is an arbitrary rate set by each individual financial institution. Because of the competitive nature of large banks, you will rarely see the prime rate of the top ten banks be different from any of the other banks. Some banks may lead or lag the market when it comes to changing prime rates, but when one big bank moves its prime, the others usually follow within hours.
At small local banks, however, the prime rate may deviate significantly from the top ten rate. In Tucson, for instance, one local bank keeps its prime rate at 1/2% over all the other major banks. When they quote a rate of prime plus 1% and a competitor bank quotes prime plus 1.5%, this is actually the same interest rate. To the uninformed customer, however, they thought they were getting a better deal at prime plus 1%. As you are dealing with banks, be sure to ask them their prime rate.
Alternatives to prime are:
LIBOR – This London-based international benchmark is the most common prime alternative. LIBOR rates have been running about 1% to 1.8% on a 30-day to 360-day basis. Although your bank may not trade in LIBOR paper, they should still have the ability to offer loans pegged to LIBOR. Traditionally over the past 20 years, LIBOR has been about 1.5% less than prime.
Treasury Notes – Particularly for longer loans or real estate deals, pegging to a five-year or ten-year treasury note is common.
Federal Funds Rate – This is the rate at which a bank can borrow from the Federal Reserve. Most banks do not offer loans pegged to this very low rate. Keep an eye on the spread between this rate and prime, however. This will tell you how much gross margin your bank is making on prime-based loans. The spread between the Federal Funds Rate and prime rates varies, which is why you should be looking at alternatives.
Internal Cost of Funds – Banks call this benchmark different names but it is their Federal Funds Rate plus a factor for their overhead costs. It is supposedly the rate at which they break even (usually 1.5% to 2.0% below prime) and is used for their best customers with major borrowings.
If you need a new loan or are considering consolidating loans, ask your banker to provide you with at least one or two alternatives to prime. An alternative rate could save you thousands in interest.
