Go to a bank in search of a commercial real estate loan and you will pay an interest rate that is determined by a combination of the prime rate and your credit worthiness. Take that same financing need to a hard money lender and your interest rate will be determined by entirely different factors.
In reality, the relationship between hard money and the prime rate is virtually nonexistent. With few exceptions, hard money lenders have their own set of criteria for determining interest rates. They care little what the prime rate is. That is one of the advantages of hard money over commercial real estate loans and small business loans.
Basics of the Prime Rate
The prime rate, also known as the ‘prime interest rate’ or the ‘prime lending rate’, is the interest rate banks charge their most valued customers. It is typically the lowest interest rate offered. Banks set the prime rate based on a combination of the federal funds rate and the overnight rate.
The federal funds rate is the interest rate banks charge to loan money to other banks from their reserve balances. The thing to understand is that banks loan excess funds to other banks on an overnight basis. That excess money is money over and above the funds deposited in federal reserve accounts to cover their deposits.
The overnight rate is the rate banks charge other financial institutions when they loan money overnight. This rate is set by the central bank in most countries. Here in the U.S., it is set by the Federal Reserve.
To calculate the prime rate, a bank considers both the federal funds rate and overnight rate to create a baseline. This baseline is generally fairly close to the overnight rate. The bank then adds a certain amount to cover its own costs and generate profit. The number they finally settle on is the prime rate.
The Prime Rate to Hard Money Lenders
Banks have to deal with the prime rate because they have to be able to cover their deposits and make a profit on loans. That’s why they start with the federal funds rate and overnight rate to set the prime rate. They are also very choosy about whom they offer the prime rate to. All but the most stellar borrowers actually pay higher rates.
None of this affects hard money lenders. Why? Because they are private lenders following an asset-based lending strategy. Consider Actium Partners as an example. Actium is a Salt Lake City, Utah lender specializing in asset-based loans. They do not loan money generated by deposits. They do not have to deposit money in the Federal Reserve account to cover customer funds.
Actium only loans its own money. Therefore, they are not beholden to the federal funds rate or overnight rate. They do not have to consider those two rates in order to set a prime rate. In fact, they do not need a prime rate at all. They can set interest rates on a case-by-case basis.
So how do hard money lenders determine interest rates? They consider two things. First is the law of supply and demand. The more in demand their money is, the higher the rates they charge. Second is the structure of each individual loan. Lenders account for the amount being loaned, the term, and the value of the asset offered as collateral. All three factors contribute to determine interest rate.
The reality is that the prime rate has very little bearing on hard money lenders. They are more interested in customizing loans and interest rates to each client.
