Demystifying How Banks Price Their Commercial Loans
Do you feel confident that your bank gives you fair consideration when quoting an interest rate on your business or commercial loan? Many business owners and real estate investors don’t realize that loan pricing—both interest rates and fees—is often negotiable. By understanding the variables that drive a bank’s loan pricing decisions, you can better position yourself to secure favorable terms.
How Banks Approach Commercial Loan Pricing
Unlike consumer loans, where rates are publicly posted, commercial loan pricing is determined case by case. Each bank uses its own internal models and policies to set rates, weighing their cost of funds, customer risk profile, the bank’s profitability targets, and competitive factors.
Since interest income is the primary revenue source for most banks, considerable resources go into ensuring loans are priced appropriately to balance their pricing criteria with regulatory capital requirements.
Commercial loan interest rates generally take one of two forms:
Fixed Rate – Constant for the entire loan term.
Variable Rate – Adjusts periodically (daily, monthly, quarterly, annually, or in longer intervals such as every 3 or 5 years).
The Benchmarks Behind Loan Pricing
At the foundation of commercial loan pricing are benchmark interest rates. These serve as the “cost base” (the cost of capital and cost of funds) to which banks add their pricing spread. For a simple illustration, let’s consider a $100,000 loan where the bank works off a 3% (or 300 basis points) spread from its benchmark rate:
Benchmark rate: 5.0%
Spread: 3.0%
Loan interest rate: 8.0%
Therefore –
Loan interest income: $100,000 x 8.0% = $8,000
Cost of funds: $100,000 x 5.0% = $5,000
Net interest income: $3,000 (per annum)
In this case, the Bank earns $3,000 before its operating (SG&A) expenses in one year on a $100,000 loan. There are other accounting variables to take into account, such as loan loss provisions, that I won’t get into to avoid complicating my point.
The most common benchmarks:
1. SOFR (Secured Overnight Financing Rate)
SOFR became the primary replacement for LIBOR (London Interbank Offered Rate) when LIBOR was phased out in 2023. It reflects the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repo market. Because it is based on actual, highly liquid transactions, SOFR is widely viewed as a transparent and reliable benchmark.
Banks and lenders actively structure new loans using SOFR today and has become the primary benchmark when LIBOR was retired for:
Larger business loans (over $5 million)
Commercial real estate construction loans and “mini-perms”
Corporate and Syndicated credit facilities
Derivatives and interest rate swaps
Most banks use SOFR for terms of 1-month, 3-month, 6-month tenors, etc. where the loan rate is adjusted accordingly based on the pre-determined spread.
2. Prime Rate
The Prime Rate is the interest rate commercial banks charge their most creditworthy customers. It generally runs about 300 basis points (3%) above the Federal Funds Rate, which is set by the Federal Reserve. So, for example, if the Fed Funds Target = 5.25% - 5.50%, then adding 3.00% would make the Prime Rate 8.50%.
This is why markets pay close attention to the Federal Open Market Committee (FOMC) meetings. Changes in the Federal Funds Rate ripple through the economy, influencing most short-term interest rates that affect borrowing costs for commercial finance, and smaller – mid-sized construction, and development loans. However, contrary to popular belief, the Fed Funds Rate does not directly determine long-term interest rates, although the Fed’s actions can influence long term rates indirectly.
The Prime Rate is the consensus rate posted by the largest U.S. banks, which in practice move together, effectively making the Prime uniform across the industry. The Prime Rate is published by the Wall Street Journal.
For many small- and mid-sized businesses, floating (variable) rate loans are priced against the Prime Rate. Most loans in this category are generally priced at Prime + 1.0% to Prime + 3.0%, and is used primarily for commercial and industrial (C&I) business loans.
3. U.S. Treasury Yields
U.S. Treasury securities—ranging from short-term bills to long-term bonds—serve as another widely used benchmark. Treasury yields are considered “risk-free” since they are backed by the full faith and credit of the U.S. government.
Banks often reference Treasury yields when pricing fixed-rate loans, especially commercial real estate mortgages. For example, a 10-year fixed commercial mortgage might be structured as: “10-Year Treasury + 2.50%.”
Another example would be with semi-variable rate loans; say a 10-year term that is priced at 5-Year Treasury + 2.50%, and re-adjusted accordingly on the 5th anniversary of the loan to the prevailing 5-Year Treasury.
4. Federal Home Loan Bank (FHLB) Advance Rates
Community and regional banks frequently rely on borrowings from the Federal Home Loan Bank system as a source of liquidity. The interest rates on these borrowings—known as FHLB Advance Rates—vary by term and are an important factor in how these institutions price loans.
When a bank’s cost of funds is tied to FHLB advances, those rates effectively become the “base cost,” and loan spreads are built on top of them, similarly to the way Treasury based loans are structured.
Both the Treasury and FHLB indices are used mainly for business term loans (such as a 5-year loan to finance equipment) and commercial real estate permanent loans.
In short:
Prime = more common for smaller, relationship driven C&I loans.
SOFR = standard for larger, sophisticated and syndicated C&I facilities and construction loans.
Treasury & FHLB Advance Rates = C&I and CRE term loans.
Treasury yields are the primary driver of long-term rates such as residential mortgages, and generally move in the same direction as FHLB advance rates since both are reflective of the broader bond market conditions. Long-term rates are influenced by several key factors:
Inflation expectations
Economic conditions and outlook
Federal Reserve policy (indirectly)
Supply and demand for bonds and Treasury securities
Risk premiums
The shape of the yield curve also plays a role in commercial loan pricing. In recent years, we have experienced flat or inverted yield curves, in contrast to the traditional “normal” upward-sloping curve where longer-term rates exceed short-term rates.
Banks generally operate more efficiently with a normal, upward-sloping yield curve. Flat or inverted yield curves can complicate match-funding strategies, which is why you’ve probably noticed short-term CD and money market rates exceeding longer-term deposit rates. The same principle applies to loans and investments.
How the Spread Is Determined
Once a benchmark is selected, banks add a spread to cover risk and achieve profitability. This spread depends on factors such as:
Borrower creditworthiness – Stronger borrowers with solid cash flow, strong financial conditions and collateral usually get preferential loan pricing.
Loan purpose and collateral – A loan secured by “hard assets” such as income-producing real estate and marketable securities may get more favorable pricing than an unsecured or secured by “soft assets” such as inventory and accounts receivable.
Loan size and relationship – Larger loan amounts or borrowers with deeper banking relationships often receive better pricing.
Market competition – Banks target specific industries (e.g. medical and healthcare) and project classes (e.g. class A multi-family) based on their strategic objectives, and therefore are likely to narrow spreads to win deals, especially during times of favorable market conditions.
Think of it like retail pricing: the benchmark rate is the bank’s “cost of goods sold,” and the spread is their markup to reach a desired net interest margin. Essentially, a lender’s net interest income is equivalent to an operating company’s gross profit.
What This Means for Borrowers
The key takeaway for business owners and real estate investors is that loan pricing is not one-size-fits-all. Because commercial loan rates are negotiable, understanding the benchmarks and how spreads are set gives you leverage in discussions with your banker.
However, loan pricing should not be the sole factor in evaluating your loan proposal. Other considerations can have just as much impact on the overall cost and value of your financing, including:
Loan-related fees
Transaction costs such as application processing and closing expenses
Loan structure, terms, conditions, and covenants
Prepayment penalties
Equally important is the quality of your banking relationship itself—particularly the level of support you receive with loan servicing and the role your banker plays as a trusted advisor and financial partner. (I’ll cover relationship banking in more detail in a separate article.)
I often remind clients that “the lowest loan rate quote is not always the best deal.” Of course, you want competitive rates and terms – and you should, but pricing should not be the only factor in your decision. Think of it like evaluating contractor bids for a home improvement project—would you automatically choose the lowest bid? Or would you want assurance of the contractor’s quality of work, reliability, and ability to stay on budget? Most of us would choose the latter.
As a business owner and entrepreneur, minimizing financing costs is important, but having a strong, dependable bank behind you is just as critical.
Final Thoughts
Commercial loan pricing may seem opaque at first, but in reality it follows a straightforward formula: benchmark rate + spread. By understanding the mechanics of this process, you place yourself in a stronger position to negotiate fairer pricing and develop a more strategic relationship with your bank.
To strengthen your negotiating position, keep these tips in mind:
Ask which benchmark is being used—and why.
Compare the spread you’re offered to market norms.
Leverage competition by exploring options from other lenders and, when possible, obtaining 2–3 proposals.
Highlight your strengths. Strong financial performance, reliable collateral, and a solid relationship history can all justify a lower spread. Banks also tend to provide preferential pricing and terms to customers who deepen their banking relationship with the lender (e.g. quality deposit balances, cash and/or wealth management services, personal and affiliated accounts, etc.) and demonstrate strong credit profiles.
At Premier Credit Insights & Solutions LLC, we guide business owners and real estate investors through the process of securing quality loan proposals—including competitive pricing. Put a well-seasoned banker in your corner to achieve optimal outcomes.
