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In the ever-evolving landscape of commercial lending, banks and private lenders alike wield variable rate commercial loans as a versatile tool to meet the diverse financing needs of businesses while managing risk effectively. Unlike fixed-rate loans, where the interest rate remains constant throughout the loan term, variable rate loans offer borrowers and lenders flexibility by allowing the interest rate to adjust in response to market conditions. In this blog, we explore the intricate process through which banks and private lenders structure variable rate commercial loans, examining the key components, considerations, and strategies involved in crafting these dynamic financial instruments. Plus, we’ll look at some of the crucial functionality in AXIS by AIO Logic that makes it simple for users to structure variable rate loans.

Benchmark Selection

Lenders typically tie the interest rates of variable rate loans to benchmark rates, such as the prime rate, LIBOR (London Interbank Offered Rate), or some other index. Selecting an appropriate benchmark is crucial, as it influences the repricing characteristics of the loan and its sensitivity to changes in market interest rates. Additionally, choosing an index with the necessary transparency is important as this provides borrowers with clarity regarding interest rate adjustments and promotes trust in the loan structuring process.

Users of AXIS by AIO Logic have plenty of flexibility when structuring interest rates for variable rate loans. In fact, AXIS provides full functionality for ten variable rate indexes including one, three, and six-month LIBOR, one and three-month term SOFR, prime rate, and more. Once the index is selected, users can then set the margin they would like to add to the indexed rate, as well as choosing the rate determination logic, which can be set to first day of the month, first day of the quarter, average of a selected number of trailing days, a selected number of days prior to the end of the month, or the actual rate on a given day.

Margin Determination

Lenders evaluate various factors, including borrower creditworthiness, market liquidity, and economic outlook, to determine the appropriate margin for variable rate loans. Margins reflect the lender’s cost of funds, risk appetite, and desired profitability targets. Lenders consider market dynamics and competitor offerings when setting margins for variable rate loans. Competitive margins attract borrowers while ensuring that the lender remains profitable and competitive within the commercial lending market.

Once the lender has decided upon the appropriate margin for the given loan, they can simply enter that margin into the Interest Rate section of the Loan record within AXIS. Once entered, the interest schedule will automatically be updated to reflect the index and margin selected. The automation of interest calculations saves the lending firm valuable time that would otherwise be dedicated to the manual calculation of said interest payments while also ensuring accuracy.

Loan Adjustment Mechanisms

Lenders establish the frequency of interest rate adjustments for variable rate loans, which can range from monthly to annually or even longer intervals. The frequency of adjustments impacts the loan’s responsiveness to changes in market interest rates and borrower cash flow management. Additionally, lenders may incorporate interest rate ceilings (maximum rate), floors (minimum rate), and spreads (fixed percentage above the benchmark) to provide borrowers with protection against extreme interest rate movements. These features enhance borrower confidence and mitigate interest rate volatility risk.

As mentioned earlier in this blog, AXIS by AIO Logic allows the lender to choose whichever one of the five rate determination logics that best suits the borrower’s needs. There is also an option to add interest intervals which allows the lender to choose a specific timeframe and set a particular interest rate for that timeframe. Additionally, AXIS allows lenders to apply index or total floors and ceilings ensure borrowers don’t pay more or less than a certain interest percentage over the course of the loan, which is crucial for times of shifting rates as we are expecting over upcoming quarters.

Borrower Communication and Transparency

Lenders prioritize transparent communication with borrowers by providing clear and comprehensive disclosure of variable rate loan terms, including adjustment mechanisms, caps, floors, and potential risks. This level of documentation is crucial to provide borrowers with the level of transparency that they deserve and have come to expect from borrower-friendly lending firms. Clear disclosure fosters borrower understanding, promotes trust, and mitigates disputes related to interest rate adjustments.

Knowing the importance of communication between borrower and lender, we included several collaboration features in AXIS’s customer portal. Among these features is the ability to collaborate through discussions, notes, and tasks. Additionally, AXIS has intelligent document management that makes it easy for both parties to access relevant disclosures and other important information. All uploaded documents are automatically stored and indexed so documents are always organized and accessible.

Monitoring and Review

Lenders continually monitor market conditions, benchmark rates, and borrower credit profiles to assess the performance and risk exposure of variable rate loans. Ongoing monitoring enables banks to proactively manage interest rate risk, identify emerging trends, and optimize loan structuring strategies. Lenders conduct periodic reviews of variable rate loan portfolios to evaluate the effectiveness of loan structuring strategies, assess borrower creditworthiness, and adjust margins or adjustment mechanisms as needed.

In order to continually monitor a borrower’s creditworthiness, AXIS provides users with powerful financial spreading and analytics features. In addition to automated vertical, horizontal, and trend analysis, AXIS also automatically triggers alerts if deteriorating financial trends are detected. Furthermore, users of AXIS can utilize portfolio analytics features to analyze the effectiveness of loan structuring strategies. Within the robust suite of automated portfolio reporting and analytics, AXIS automates the tracking of key portfolio performance KPIs including total yield, cumulative charge-off rate, default rate, and other metrics that give insight into the effectiveness of loan structuring.

Conclusion

In conclusion, the structuring of variable rate commercial loans is a multifaceted process that requires careful consideration of benchmark selection, margin determination, adjustment mechanisms, borrower communication, and ongoing monitoring. By crafting variable rate loans with transparency, flexibility, and responsiveness to market conditions, lenders can offer borrowers tailored financing solutions while effectively managing interest rate risk and optimizing returns in the dynamic landscape of commercial lending. If your firm is seeking a loan management platform that allows for simple and effective interest rate structuring functionality, please feel free to contact us today to schedule an intro call and learn more about all that AXIS has to offer!