Margin is the difference (“spread”) between the total interest rate charged on a loan and its reference base rate (e.g., LIBOR). It reflects the borrower’s credit quality and, thus, must be sufficient to compensate lenders/investors for the credit risk the loan exposes them to when holding it. A margin may either remain fixed throughout the loan period or vary according to a specified formula at different.
Anticipated borrower liquidity problems have a positive effect on the upfront fee the lender(s) charge but do not impact the interest spread.
In commercial lending, banks quote interest rates in reference to the lender’s cost of funds or a wholesale rate based on the term of the loan. A base rate is the reference market rate (e.g., LIBOR or EURIBOR) used by lenders for calculating their interest cost they incur in obtaining funding in the required amount, interest period and currency under a financing facility. It is then added to the margin to arrive at the loan interest rate.
Lead banks make some adjustments in pricing for nearly 80% of loans, indicating that new information is frequently generated and incorporated during the underwriting process.
The higher a lender’s quality, the lower the cost of funds it can lend. Participants (small banks, institutions, CDOs, hedge funds) earn only a margin over their cost of funds and do not receive any of the underwriting spread or closing fee.