Commercial mortgage interest rates are a combination of the margin that the bank changes and the index that they use. For example if a bank quoted Prime (the index) plus 2% (the margin) you're actual or “effective interest rate" would be 7% (Prime is currently at 5%).
Lenders use a wide range of indexes. On owner occupant transactions Prime is still very popular and is used much of the time. This is especially true with floating rate loans. The SBA 7a program still uses Prime for example. Commercial investment deals use a broad range of indexes. The treasuries are popular but each individual lender has their preferences. The index used is probably less important for the borrower than the margin that the funding bank uses.
The margin is basically how the bank makes its money and its spread. The bank typically is borrowing the money that they lend and therefore has a cost of capital. The spread is the difference between what they pay for their sources of capital and what they make off of lending money.
Creating or pricing out the margin is no easy task. It's a complicated process as the bank has to be competitive in order to win deals yet not quote margins to “skinny" as to not make enough money. Banks have to essentially predict the future and take into account a percentage of default, cover future costs, and of course try to make a profit.
The combination of the margin and index is commonly referred to as the Effective Rate. It's what the borrower uses to figure out their payments. For instance, if a lender quoted you 5 Year SWAP (Currently at 3.9%)plus 2.5% your Effective Rate would be 6.4%.
One of the odd things that we have seen in the last year is the fattening of margins which comes as a surprise to many borrowers. Many assume when they hear that “interest rates" have been lowered by the Feds that it means that there potential interest rates on loans have been reduced. What it really means is that the cost of capital for the banks has been lowered but that doesn't mean that the banks have kept their margin the same as a year ago. For example, margins in January 2007, where commonly 2%, now it's not uncommon to see margins at around 4%. So the borrower's effective rate is the same or in many cases actually higher than it would have been before the Fed lowered rates.
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