How Are Commercial Loan Rates Determined?

Financing is a necessity for making high-value real estate investments. Finding proper financing makes all the difference in an investor’s ability to access the best real estate offers as an asset class.

The critical area investors need to determine good financing options from bad ones is the loan. When loan rates are more favorable to an investor’s interests, they can feel more confident moving forward with their investments.

Explore the nuances of how commercial loan rates are determined so you can know what to look for when you assess your financing options.

What Are Commercial Loans?

Investors can turn to many different types of loans. Commercial real estate loans are specific types of loans tailored for commercial real estate sector investments. They come with an amortization period that outlasts the loan term.

Commercial real estate has a higher purchase price than residential and other property types. Commercial properties tend to be much larger than single-family homes and even multi-family homes.

Furthermore, commercial real estate tenants tend to be businesses or office buildings, meaning property owners have a stronger bargaining position to close at a higher price. Companies tend to have better capital and cash flow access than individuals putting money down on a residential property.

Investors and businesses may take out commercial loans to finance or refinance their commercial property. Commercial real estate assets are increasingly lucrative investment property businesses, and investors can better access the right loan program for a down payment.

What Are Loan Rates?

Loan rates refer to the percentage of interest borrowers are expected to pay on their loans. A typical commercial loan rate can range between 3 to 20%.

The high degree of variance is due to the many factors that influence the set interest rate of a loan. Taking inventory of these factors can help investors find the most reasonable commercial real estate loans that suit their interests.

What Factors Determine Commercial Loan Rates?

  • Prime Rate
  • Personal Credit
  • Term of the Loan

Prime Rate

The prime rate of a commercial loan refers to the best interest rate for loans on the market. The prime rate is usually on the lower end, as it is used as a benchmark for other financial services: lines of credit or credit cards. The current prime rate is 7% of interest on the loan.

Prime rates are established by the Federal Reserve, distinct from the U.S. treasury, through the federal funds target rate. Banks use the federal funds target rate to determine their loan rates. The prime rate is the federal funds target rate plus three.

When the Federal Reserve takes action and raises or lowers the federal funds target rate, the prime rate also changes. Because the prime rate sets the baseline for rates across the financial sector, its fluctuations have a massive influence.

Attaining a prime-rate loan may be difficult for individual creditors. More often than not, only large, incorporated financial institutions (such as banks and investment companies) are charged the prime rate.

Large financial institutions, like commercial banks, have the capital and resources to pay off their loans quickly and reliably.

Personal Credit

The creditor’s personal credit history significantly impacts a loan’s interest rate. Credit history is a straightforward metric that establishes a creditor’s financial decisions in the past.

Good personal credit indicates creditworthiness; a creditor with a good financial credit score establishes their ability to pay off loans on time and in full.

Credit scores range from 300 to 850. Credit score levels are staggered by their corresponding levels:

Poor: 300 to 579

Fair: 580 to 669

Good: 670 to 739

Very Good: 740 to 799

Excellent: 800 to 850

The better a creditor’s credit score, the more favorable their loan rate will be. Lenders will give borrowers with higher credit scores lower interest rates because their score indicates they are trustworthy enough to pay off their loan properly.

Maintaining an improved credit rating depends on a wide range of financial decisions. Loan history, loan amount, delay in paying off loans, and active debt can affect a creditor’s credit score.

Term of the Loan

The length of the loan will affect the interest rate charged to the creditor. Lenders are more hesitant to give away longer-term loans as there is an increased opportunity for failure to pay them off.

Moreover, dispersing loan repayment over a longer-term means that creditors pay less over time; therefore, they are less incentivized to pay off their loans quickly.

Borrowers necessarily want to see their loans paid out sooner than later. A loan paid longer-term will then incur a higher interest rate to offset lower monthly payments to the lender.

Alternatively, short-term loans will have lower interest rates; their larger monthly payments mean that borrowers pay off their loans sooner.

For creditors looking for lower interest rates on their commercial loans, opting for shorter-term loans will keep their rates down. The trade-off for the lower interest rate is the higher monthly payments.

However, if creditors have the financial means to take on shorter-term loans, they will benefit: paying shorter-term loans don’t just have lower interest rates; they are better for building one’s credit score.

Other Factors That Can Impact Commercial Loan Rates

While prime rates, personal credit, and loan terms are the primary factors that influence commercial loan rates, they are not the only things that play a role. Some other factors that can impact commercial loan rates include the following:

  • Loan-to-value ratio (LTV): LTVs compare the size of your loan (usually a mortgage) to the value of the asset (traditionally a home) you’re buying or refinancing. A higher LTV is associated with higher risk and can lead to a higher commercial loan rate.
  • Size of loan product: Similar to LTV, the size loan you request will influence the loan rate you’re able to secure (generally, an unusually big or small-sized loan will come with higher rates than an average-sized loan)
  • Type of loan (commercial mortgage loan, hard money loan, SBA 504 loan): Some types of loans carry more risk than others. Generally, the riskier the loan you apply for, the higher the commercial rates you can expect.
  • Debt service coverage ratio (DSCR): Typically, lower DSCRs translate to higher interest rates.
  • Fixed interest rate and variable rate: Variable rates tend to come with lower, more competitive rates than fixed interest rate loans; however, be sure to research the current economic conditions to ensure this is the case for you.

How To Get a Good Commercial Loan Rate?

Knowing the factors determining loan rates is vital to finding a good loan. Identifying where to look to see these factors in action helps investors know where, when, and how they can find reasonable commercial loan rates.

  • Look at the Economy
  • Find the Average Rate
  • Build Your Credit Score

Look at the Economy

Taking notice of more extensive market conditions is crucial to getting a reasonable loan rate. Strong economies translate into more favorable commercial mortgage rates. The Federal Reserve will keep interest rates low to encourage spending when the economy is strong.

The Federal Reserve will raise interest rates in a weak economy to quell spending. For example, taking loans during periods of inflation results in unfavorable rates.

The Fed raises interest rates in an attempt to thwart ballooning prices. With the current state of the global economy, inflation may soon result in higher interest rates.

Find the Average Interest Rate

The best way to get a sense of the current state of interest is by assessing the average interest rate. The average commercial loan interest rate considers sector-wide rates across the financial world. By determining the average interest rate across the sector, investors have a strong sense of where current de facto rates are.

The current average interest rate in the United States is around 4 to 5%. The range of commercial loan interest rates can range from 2.2% to 18%.

The average rate may vary depending on the loans investors choose: a bridge loan, a bank loan, and other loan options. Lower average interest rates now might encourage investors to seize an opportune moment to start financing before interest rates get worse.

Build Your Credit Score

The better a creditor’s credit score, the more favorable their interest rates. Building a better credit score is critical to securing one’s financial health. Better credit scores open up a world of opportunities; creditors can gain more favorable rates for their loans and a number of perks.

Building a better credit score starts with taking on more substantial loans, then paying them off on time. While it may seem counterintuitive, taking on more debt is key to building better credit. By taking on a commercial loan to procure better investments, you can build a better credit score at the same time.

The Bottom Line

When you know how commercial loan rates are determined, you’re equipped with the know-how to choose better financing options.

While rates may be higher than they have been for the past decade, they are far lower than their historic high; in the 1980s, interest rates reached the highest level for the past half-century.

Loanbase has the resources to connect eager investors with the best commercial loan rates available. Check out our databases to see the ideal loans in your area.

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