Understanding Interest Rates in Commercial Finance: Components, Structures, and Influencing Factor
Understanding Interest Rates
The terms of lending depend on the borrower’s relative risk of default, which is determined by a bespoke risk grading system incorporating qualitative and quantitative measures. This risk grading also establishes the required Return on Equity (ROE) for the business, serving as the basis for the lender’s rate pricing and fee model.
It considers the probability of default based on the risk grade and calculates the “loss given default” to determine the capital cost requirement based on the lender’s cost of funds.
Interest Rate Structure
Unlike mortgages, business customers often have uncertainty about the interest rates for their commercial finance. Small and medium-sized enterprise (SME) loans are typically presented as a simple all-inclusive interest rate. However, larger loans are usually linked to a market-based interest rate with added margins and costs.
Interest Rate Components
Base Rate – In simple terms, a commercial loan is based on a Bank Bill Swap Bid Rate (BBSY) or a similar benchmark at which the financier borrows money.
Margin – The customer margin is determined by factors like character, capacity, and capital. The interest rate on a bill facility is reset at rollover, based on the current base rate plus the margin. For example, it might be quoted as 2.5% over BBSY.
Line fees – Are payable to maintain credit availability, and interest is charged only on the loan balance.
Interest Rates Offered
Are influenced by
- The primary purpose of the funding
- Risk grading
- The quality of collateral provided (unsecured funding typically results in higher interest rates)
- Loan-to-Value Ratio (LVR) based on the collateral provided (higher LVR increases pricing)
- The strength of the capacity to service the debt using various measures
- Loan Term
Conclusion
This article delves into the intricate world of interest rates in commercial finance, emphasizing the role of risk grading in determining lending terms based on borrowers’ risk profiles and Return on Equity (ROE) requirements. The article sheds light on the interest rate structure, contrasting SME loans with market-based interest rates for larger loans.
Additionally, it explores the key components of interest rates, including Base Rate, Margin, and Line Fees, and discusses the various factors influencing the interest rates offered, such as risk grading, collateral quality, Loan-to-Value Ratio (LVR), capacity to service debt, loan purpose, and term.
Don’t miss the opportunity to gain valuable insights that can shape your financial decisions and open new doors for your business! Book an appointment now to discuss the components, structures, and influencing factors of interest rates in commercial finance.
Disclaimer: The information provided in this blog is for educational purposes only and should not be considered financial advice. Always consult with a professional financial advisor or lender for specific lending decisions.
