For a small business borrower, the simple answer to this question is pretty much nothing. If you have an ARM mortgage on your home, you also aren’t likely to see much drop in your interest rate.
“Why?” you ask.
Because the Fed Funds rate, while being an important monetary benchmark, isn’t the benchmark for business loans or residential mortgages.
The Fed Funds rate is the rate the U.S. Federal Reserve Bank charges banks who borrow from the Fed. However, because most U.S. banks have not loosened their purse strings since the banking crisis started, they aren’t lending money except to the strongest customers; therefore they don’t really need to borrow from the Fed right now. The reason the Federal government is making nearly $200 billion available to banks to help improve their liquidity is to encourage banks to loan money out. Banks are just not biting right now and seem to be taking a wait-and-see approach to the recession. If it gets worse, they will continue to hold their cash; if signs of an improving market start showing up, credit will loosen some.
Let me focus first on the impact on business borrowers. Business borrowers who have variable-rate notes may see a slight drop in their interest rate. This is because the Wall Street Prime Rate, which is one of the standard benchmarks used in business borrowing, usually tracks up and down with the Fed Funds rate. Yesterday when the Fed Funds rate dropped from 1.5 percent to 1 percent, the Wall Street Prime Rate dropped from 4.5 to 4 percent.
Interest rates on typical business loans are priced from 0 percent above prime rate to about 3 percent above prime. So in theory, if the Fed Funds rate does drop to 0 percent, we may seen Wall Street Prime drop to 3 percent. But here is the rub: Many loan agreements made during the last 3-5 years have put a floor on the lowest rate they will go while it is floating. Most of them that I have seen were set to 4 percent. So if your business loan is floating and has a rate floor of 4 percent for New York Prime, then you won’t see any further reduction in rates.
Another method that I have seen very recently of calculating floating interest rates for business is an either-or method of calculating the benchmark by which your loan rate floats. For example, a lender who I am working with now for a $3.5 million asset-based line of credit has priced the loan at Wall Street Prime 2 percent or LIBOR 1 percent.
What is LIBOR and why should I care?
LIBOR stands for London Inter-Bank Offer Rate. LIBOR is used in international transactions nearly exclusively as a benchmark floating loan rate, but
The bottom line is if Fed Funds does move from 1 percent to 0 percent as some are predicting, business loans will not likely see a benefit because of the rate floor provision, or because the calculation may change from LIBOR, assuming it is higher.
If you are a mortgage borrower, it is unusual for your loan to be tied to Wall Street Journal prime. Mortgage rates are usually tied to longer term benchmarks. Today while variable rate business loans were going down 1/2 percent, the benchmark 30 year fixed-rate rose .46 percent to 6.77 percent.
The bottom line is if you are confused after reading this, don’t feel alone. There is not much logic being used in moving the benchmarks around when banks just won’t let go of their cash.