There was a time when all business loans were priced according to the prime rate. Today, many middle market borrowers may select the pricing mechanisms for their short term loans. Understanding your options and their associated advantages and disadvantages will help you make a better informed choice when borrowing funds.
Loans priced using "prime," the bank's prime commercial lending rate, are the least complicated for both the borrower and the bank. Prime is a floating rate, established by each bank based on its overall cost of obtaining the monies to fund the loan. The bank's spread is already included in the rate and any market fluctuations during the term of the loan are passed on to the borrower directly. An additional increment added to or subtracted from prime reflects the creditworthiness of the borrower - the greater the perceived credit risk of the borrower, the greater the price.
Historically, banks have funded prime rate loans with the bank's own deposits, including consumer and corporate demand and time deposit accounts. Recently, as loan growth has outpaced deposit growth, banks have purchased wholesale funding for the loans.
Some prime loans are made on a discretionary demand basis, meaning the bank can call or demand repayment at any time and the borrower is free to prepay a portion of the entire amount of the loan without penalty.
Prime loans are relatively easy for the borrower to initiate. Once a facility is in place, the bank can be informed of a borrowing the same day funds are required and there are low or no minimum draw amounts. In fact, many automated systems allow the borrower to call the bank's computer with the company's daily borrowing requirement.
Based on the demand for alternative pricing structures, many corporate borrowers now have the option of tying their loan rates to the eurodollar market. Eurodollars are U.S. dollar deposits held anywhere outside of the U.S. For instance, a U.S. dollar deposited in a bank's Grand Cayman branch is a eurodollar deposit. The eurodollar market gives rise to LIBOR, or the London Interbank Offered Rate.
LIBOR is an index or snapshot of the eurodollar market at a particular point of time. Each business day at 11:00 a.m. London time, London's major banks are asked where eurodollars are trading. These rates become LIBOR. After LIBOR is set, eurodollars continue to trade freely, above and below LIBOR. LIBOR more accurately reflects the bank's marginal cost of funds than prime, however, as with prime loans, an incremental percentage above or below LIBOR is usually assessed to address the relative creditworthiness of the borrower.
Appeal of Eurodollar
Several features make the eurodollar market very appealing as a source of funds:
1) The market is global
2) It trades around the clock
3) It is unencumbered by government regulation
4) It rivals the U.S. Treasury market in size and liquidity.
Eurodollar facilities carry a fixed interest rate for the borrowing period with maturities ranging from one day to one year.
Unlike a prime based loan, LIBOR loan facilities may subject the borrower to a prepayment premium if the loan is prepaid in whole or in part prior to maturity. The premium is calculated by comparing the interest the bank would have earned if the loan were not prepaid to the interest earned from reinvesting the prepaid amount at current market levels.
Recall that prime based loans require the borrower to give little or no advance notice of a borrowing to the bank. …