How is interest on a revolving line of credit priced?

The two parts of the rate

Interest on a revolving line floats. For each interest period the lender takes a base rate that moves with the market and adds a spread, also called the margin, that stays fixed unless the agreement says otherwise. The result is the rate charged on every dollar drawn during that period.

Two base rates cover almost every business line in the United States:

• SOFR, the Secured Overnight Financing Rate. Most loan agreements use term SOFR, a forward-looking one-month or three-month rate fixed at the start of each interest period, so you know the rate for the month ahead. Some agreements still carry a small fixed add-on called a credit spread adjustment, left over from the move away from LIBOR. Read it as part of the spread.
• Prime, a rate each bank publishes and changes when the Federal Reserve moves. Community and regional banks often price smaller lines off prime. Prime sits well above SOFR, so a prime-based offer carries a smaller spread than a SOFR-based offer with the same all-in rate. Compare the totals, not the spreads. SOFR versus prime covers the difference in detail.

The spread is the lender's price for your risk and its own cost of money. It reflects the kind of line, the quality of the collateral, leverage, the size of the facility, the deposits you keep with the lender, and how the lender is funded. Banks lend deposits; non-bank asset-based lenders and private credit funds fund themselves with costlier capital and price accordingly. That is one reason the same borrower sees very different spreads from a bank and a finance company, as bank versus non-bank ABL explains.

The spread is fixed at signing; the base rate is not. When market rates rise, every dollar on the line costs more from the next interest period.

Floors, caps and hedging

An interest rate floor sets a minimum for the base rate. If term SOFR falls below the floor, interest is calculated as if it stood at the floor. Floors protect the lender's yield when rates fall, and they matter most when a line is signed near the bottom of a rate cycle. Three things are worth reading closely: whether the floor applies to the base rate or to the whole rate, the level it is set at, and whether it applies to any part of the balance you have hedged.

Revolver balances move every day, so they are rarely swapped to a fixed rate. Where a lender asks for hedging, it usually attaches to the term loan beside the line; see interest rate hedging requirements and swaps versus caps.

The one hard ceiling on revolver pricing comes from SBA. A working capital line made under SBA's CAPLines program is a 7(a) loan, so SBA's rate caps apply: the base rate plus 6.5% for loans of $50,000 or less, plus 6% from $50,001 to $250,000, plus 4.5% from $250,001 to $350,000, and plus 3% above $350,000. The current base rates and caps are on SBA loan rates, and the rule itself is under SBA maximum interest rate. Conventional lines carry no SBA cap; their price is whatever the agreement sets.

Pricing grids: a spread that moves with you

Many committed revolvers price off a pricing grid rather than a single spread. The grid sets several tiers, and the spread steps down as your measured risk falls and up as it rises. What the grid is keyed to depends on how the line is underwritten.

An excess-availability grid has a quirk worth understanding before signing. A business that draws heavily both pays interest on a larger balance and moves to a higher-spread tier, so its interest cost rises faster than its usage. A leverage grid behaves similarly after a weak year: EBITDA falls, leverage rises, and the spread steps up at the moment cash is tightest.

When reviewing a grid, check:

• Which tier applies at closing, and whether it is held there until the first test date
• How EBITDA is defined for the test. The covenant definition may allow addbacks your own reporting does not show
• When a change takes effect, usually the first day after the certificate is delivered
• What happens if a certificate is late. Many agreements move you to the most expensive tier until it arrives

What you pay on the part you don't draw

Interest runs only on the drawn balance. The undrawn commitment carries an unused line fee, usually charged quarterly in arrears on the average undrawn amount. It pays the lender for holding capital against a commitment it has promised to fund.

On an asset-based line the fee is usually calculated on the commitment less average usage, not on the borrowing base. A business whose borrowing base supports less than the full commitment therefore pays a fee on room it cannot draw. Sizing the commitment close to the realistic peak of the borrowing base, as sizing a working capital line describes, avoids paying for headroom that never exists.

Two other charges attach to the commitment rather than the balance. Letters of credit issued under the line count as usage and carry their own fee, often priced near the spread, plus a fronting fee to the issuing bank. And most lines carry an origination or closing fee on the commitment, which should be spread over the expected life of the line when you compare offers.

The costs that come with asset-based lines

An asset-based lender prices the monitoring it does, and some of that cost sits outside the spread entirely:

• Collateral monitoring fee. A flat monthly charge for administering the borrowing base, reviewing certificates and running the loan account.
• Field exams and appraisals. Paid by the borrower, with frequency set in the agreement and often increased when availability runs low. See the field exam.
• Clearance days. When customer payments arrive in the lender-controlled account, some lenders credit them to your loan only after a fixed number of business days written into the agreement, while interest keeps running on the full balance. The cost scales with your collections, not your balance.
• Minimum interest or minimum usage. Some non-bank lenders charge interest as if a minimum balance were drawn, whether or not it is.
• Treasury and lockbox charges. The cost of the lockbox and controlled accounts the lender requires.
• Exit terms. Not a running cost, but part of the all-in number if you may refinance before maturity. See early termination fees.

Clearance days are the easiest to miss. Suppose a business collects 30,000 a year through the lockbox and the agreement sets two clearance days. It pays interest on two extra days of every collection, which over a year equals carrying about 167 of balance for the whole year (30,000 times two, divided by 360) that it never actually used. A business that turns its receivables quickly pays more for clearance days relative to its average balance than a slow-collecting one.

Building an all-in number

The only fair way to compare two lines is to cost each one at the usage you actually expect. The example below takes two offers for a commitment of 5,000. Offer A is a bank cash-flow line with a higher spread and no monitoring costs. Offer B is a non-bank asset-based line with a lower spread, a monitoring fee, annual exams and two clearance days on 30,000 of collections. Each is costed at light usage (2,000 drawn on average) and heavy usage (4,000).

Offer B's lower spread looks cheaper on the term sheet. At light usage it is the more expensive line, because its fixed costs are spread over a small balance. At heavy usage the two cost the same. Which offer wins depends on the average balance, and that number should come from a monthly cash forecast, not a guess.

Three refinements make the comparison honest. Add one-off fees spread over the years you expect to keep the line. Run the base rate at a level below the floor, if there is one, to see what the floor costs you. And price each grid at the tier you will actually be in, not the best tier on the page. Interest rate versus all-in cost applies the same method to term loans.

A cheaper line that gives you less availability is not cheaper. Compare cost only between offers that fund the business you actually run.

Price is one term among several

Pricing is the easiest term to compare and rarely the one that decides whether a line works. Advance rates, eligibility rules and reserves decide how much you can draw. Covenants decide when the lender can stop you drawing. Reporting decides how much of your controller's month the line consumes. A spread that is slightly higher on a line with better availability and lighter covenants is often the better deal.

Transparent's lender book holds 235 lenders that write asset-based loans and lines, and the financing model in the lender package projects the borrowing base and usage month by month. That lets term sheets from banks and finance companies be set side by side on one all-in basis, at the balance the business will really carry, rather than on the headline spread each lender leads with.