If you’ve wondered how bankers set interest rates, the answer is quite simple. They set rates at the highest level the market will bear. With most banks, however, pricing is a bit more complicated than that. Here’s inside information, directly from commercial loan officers, about how they set rates and tips to achieve lower rates the next time you borrow.
Rates and Risk
Bankers theoretically set rates according to the perceived risk of loan default or non-payment. It stands to reason, that the more you, the borrower, do to reduce that risk, the more you will be rewarded with lower loan interest rates. To reduce banker-perceived risk, do the following:
- Retain annual earnings in order to build a large net worth. (Net worth is defined as the total of stock + paid in capital + retained earnings as a percentage of total assets.) Bankers want no less than 25% net worth, but feel really secure when net worth is 50% or more. Net worth reduces risk by providing a cushion for any future losses. The down side of building net worth for c-corporations, however, is double taxation at the time the company is sold or dividends are taken.
- Operate your business for high bottom-line profits. Although this is easier said than done, bankers feel warm and fuzzy (which translates to lower rates) when your bottom-line is fat. What is fat? Any profit in excess of the industry average profit for that time period.
- Offer high-quality collateral. Although bankers will tell you they don’t rely on collateral to pay loans (they correctly say that only cash flow pays loans), they feel more secure when they have collateral they could easily convert to cash at a moment’s notice.
This desire for cash collateral means real estate is one of their least favorite things. Vehicles (easily confiscated, driven off and sold) are more to their liking. Ideally, bankers prefer to have a collateral position on everything you own or could ever think of owning in the future. (Contrary to popular belief, however, they don’t want your first born — bankers really are smarter than that!)
Rates and Total Account Earnings
In more sophisticated banks, rates are also set to provide a specified return on asset to the institution. (Your loan is considered their asset.) This means that the more business you do with the bank — checking accounts, cash management, investments, etc. — the more profit already factored into the equation when your rate is set. Theoretically, the more non-loan business you do with your bank, the lower your rate.
To lower your interest rate, therefore, consider doing all your business with one bank, including your personal banking and trust services. If the bank’s fees are comparable to any outside vendor, you are better off having a portion of the non-loan fees credited toward your borrowing rates.
For example, one bank’s pricing formula takes the loan amount times a 10% desired return on asset. Let’s use an example of a $1,000,000 loan with a desired return of $100,000 for a year. If the borrower had no other business with the bank, the bank would need to charge 10% interest to achieve its desired return.
On the other hand, if the borrower paid fees for various services such as cash management, payroll processing, a trust account, and collected funds on deposit, the bank would credit a one-third portion of these net proceeds towards the loan. With a $10,000 credit for the extra profit from these non-loan services, the bank would only need $90,000 in interest to make its desired $100,000 return. This means the loan would could be priced at only 9%, a full point less than the borrower with no other services.
The Competitive Climate
Although you might think that rates would be reasonably uniform throughout the U.S., this is not true. There are vast regional differences in interest rates and desired yields.
No matter what your geographic region, however, big banks are a little quicker to sharpen the pencil on rates when they know they must compete for your loan. Bidding out your banking relationship (including deposits and other services), therefore, may help you achieve lower loan rates. Because the bidding process is quite costly to banks, we suggest using the bid process only once every three years.
In rural communities, bidding may not be as attractive. Small community banks often place emphasis on customer loyalty and tend to reward borrower loyalty automatically through low rates. At these banks, bidding can be perceived as a slap in the face and cause rates to be increased, not be lowered! If you are in a rural community, compare your rate with fellow business owners of similar business profile and financial condition to see if your rates are competitive. Use your charm, loyalty and negotiating skills to lower your rates.
In summary, take the lead when it comes to your borrowing rates. You can make an impact.
