Business Finance Fundamentals: Five Factors For Lower Loan Interest Expense

Your interest rate is a key loan term. How is it determined? How can you pay the lowest possible interest expense?

Why does the interest rate matter? The interest rate determines your loan payment. A lower interest rate equals less loan interest expense. Also, the loan size is limited in part by the debt service coverage ratio which is calculated using the annual loan payments. The smart borrower understands the critical role and components of the commercial loan interest rate when evaluating financing.

Fixed or floating? A fixed rate loan has a constant interest rate used to calculate the periodic loan payment. The constant payment can give the borrower confidence in capital planning with a known debt service requirement. A floating rate loan uses a variable index such as Prime or LIBOR (London Interbank Offering Rate) to calculate the loan payment. The floating index resets from time-to-time according to the terms of the loan agreement. A floating rate loan typically has a lower interest rate compared to a fixed rate loan. However, the annual budget for debt service is difficult to determine with accuracy since the rate can fluctuate. There are many ways to control floating rate exposure through LIBOR fixes and interest rate caps and swaps. Choose fixed or floating to match your needs.

The interest calculation method matters: Lenders use different methods to calculate the amount of interest that accrues during a period. One popular method takes the actual number of days in a period, for example a month, and divides it by a 360-day year. This calculation naturally provides a built in profit for the lender because there are five extra days of interest, six in a leap year. A standard calculation among life insurance companies is the 30/360 method which uses twelve 30-day months over a 360-day year to calculate interest. This method ultimately returns 100% of the annual interest but the interest accrual in short months works to the benefit of the lender and long months are in favor of the borrower. Fixed rate loans have a constant payment but the amount of interest applied to each payment can vary depending on the method used to calculate periodic interest. Pay attention to the calculation method when choosing a loan.

Know the components of the all-in rate: The index is the base layer used to calculate interest. There are many indexes used in lending. The most common are the bank Prime lending rate, LIBOR, and United States Treasury notes. Floating rate loans tend to use Prime or LIBOR as the index while fixed rate loans are typically priced using Treasury rates. Lenders address the increased default risk premium above Treasuries by using the swap rate. The Treasury index plus the swap spread (default premium) is the swap rate to which the lender adds the borrower's credit spread. The credit spread is unique to a particular borrower and takes into account the collateral, borrower sponsorship, credit history, market conditions and other factors. The lender's credit committee determines the borrower's credit spread. The index and the credit spread determine the all-in loan interest rate used to calculate the periodic payments.

Learn to burn down your spread: Some lenders are willing to reduce the floating rate index or the fixed rate of your loan after you meet certain performance conditions. For example, a construction lender might reduce your loan spread after completion of construction. Other triggers for an interest spread reduction may include achieving a certain debt service coverage level or improving the value of the collateral. Be aware of triggers that will cause the interest spread or rate to revert or claw-back to the original level. Ask for an interest rate or spread reduction hurdle during loan negotiation to potentially lower your future debt service payments.

Ask for interest-only payments: Some lenders are willing to write loans that have all or part of the loan term on an interest-only basis. A conventional loan has periodic principal and interest payments which amortizes the principal balance over time. An interest-only loan defers repayment of principal until sometime later in the term, many times until the maturity date. The periodic loan payment is lower because the principal component is deferred. Your cash flow is greater because of lower debt service payments but the principal balance must be repaid later so be prepared with take-out financing at maturity.

You can lower your loan interest expense by paying close attention to the interest rate structure. Be a shrewd businessperson by negotiating favorable interest rate terms in your loan agreement.