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Unformatted text preview: rowers by adding a premium to the prime rate to
adjust it for the borrower’s “riskiness.” The premium may amount to 4 percent
or more, although most unsecured short-term loans carry premiums of less than 2
Fixed- and Floating-Rate Loans Loans can have either fixed or floating
interest rates. On a fixed-rate loan, the rate of interest is determined at a set increment above the prime rate on the date of the loan and remains unvarying at that
fixed rate until maturity. On a floating-rate loan, the increment above the prime
rate is initially established, and the rate of interest is allowed to “float,” or vary,
above prime as the prime rate varies until maturity. Generally, the increment
above the prime rate will be lower on a floating-rate loan than on a fixed-rate
loan of equivalent risk, because the lender bears less risk with a floating-rate
loan. As a result of the volatile nature of the prime rate during recent years, today
most short-term business loans are floating-rate loans.
Method of Computing Interest Once the nominal (or stated) annual rate is
established, the method of computing interest is determined. Interest can be paid
either when a loan matures or in advance. If interest is paid at maturity, the effective (or true) annual rate—the actual rate of interest paid—for an assumed 1-year
period6 is equal to
Amount borrowed (15.3) Most bank loans to businesses require the interest payment at maturity. 3. A trend away from using the prime rate as a benchmark has begun in the United States in response to various borrower lawsuits against banks. Some banks now use the term base rate or reference rate rather than prime rate for
pricing corporate and other loans. In fact, the use of the London Interbank Offered Rate (LIBOR) is gaining
momentum as a base lending rate in the United States.
4. During the past 25 years, the prime rate has varied from a record high of 21.5% (December 1980) to a low of
4.75% (December 2001 through the mid...
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