Fed cuts pay off for small businesses

(FORTUNE Small Business) -- Dear FSB: How do the Fed rate cuts affect business loans, if at all? Say I take out a loan for several hundred thousand dollars to buy a small business. What criteria is used to set the interest rate on the loan?

- Brent, Houston, Tex.

Dear Brent: The Fed's rate cuts are good for small-business owners seeking loans.

"Small business borrowers will see relief as a result of the feds repeated interest rate cuts," says Greg McBride, senior financial analyst with Bankrate.com. "This is particularly true for borrowers with variable or adjustable rate loans, as those loans can be pegged to indexes such as the prime rate, which moves in step with the federal interest rate and the LIBOR - the London Interbank Offered Rate. That's a rate at which banks pay to borrow from each other that is used as a global interest rate benchmark."

Since many small-business loans are variable-rate loans, as the Fed cuts rates and the prime rate goes down, they become more affordable, says George Harrop, Chief Executive Officer of Mainstreet Lender, a Chevy Chase, Md., non-bank lender specializing in the needs of small-business borrowers.

"It's a benefit to small business owners because it means they'll be spending less of their cash flow on servicing the loan, and in the eyes of the lender, they become a stronger borrower, because less of their money goes toward paying the loan and more goes toward running the business," Harrop said.

When lenders set rates for borrowers, they're seeking to manage risk, says Harrop.

"Risk is being viewed through a different lens now than in recent years," says McBride. "It's tougher to obtain credit, and credit will come at a higher price now that some sanity is returning to the lending environment. Borrowers banks perceive as riskier - those that pose a higher likelihood of delinquency or default either due to previous late payments or other financial difficulties - can be expected to pay higher interest rates."

If the business is already established, or if the borrower has a history of successfully repaying loans, that will also affect their rate, says Harrop.

"Banks are interested in a relationship, [not] a transaction," says Alfred F. Luhr III, senior vice president of business banking at M & T Bank in Buffalo, N.Y. "The more you can bring a relationship to a bank - your personal account, home mortgages, any kind of business you have - it will help with the rate."