What is The Prime Rate? A Guide to Prime Rates in Finance
Written by MasterClass
Last updated: Aug 10, 2021 • 2 min read
The prime rate is the lowest interest rate that banks and other financial lenders charge to their most reliable borrowers. Though civilians rarely qualify for the prime rate on loans, the prime rate sets a benchmark for interest rates on other loans that they take out.
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What Is the Prime Rate?
The US prime rate is the interest rate that commercial banks charge to their most reliable, least risky borrowers. This variable interest rate is linked to the federal funds rate, an overnight rate that banks use to lend to each other. Prime rate fluctuates depending on the health of the economy and changes to the federal funds rate.
Civilians won’t typically qualify for the prime rate; it is usually reserved for large corporate borrowers. However, the prime rate sets a benchmark for other kinds of interest rates, including short-term loans, personal loans, auto loans, business loans, student loans, home equity loans, adjustable-rate mortgages, and credit card rates.
How Does the Prime Rate Work?
The prime interest rate, also known as the prime lending rate, is the lowest interest rate that a bank can offer to a borrower on a loan or a line of credit. Lenders can offer a lower interest rate to customers who have the lowest risk of defaulting on their loan, because there is less risk to mitigate. The prime rate acts as the benchmark interest rate for a bank's biggest and lowest-risk borrowers.
Financial institutions set their own prime rates, so there is no single prime rate. The most commonly-used metric to gauge the current average prime rate is published by The Wall Street Journal daily. The Wall Street Journal prime rate is determined by averaging the rate on corporate loans from at least 70 percent of the 10 largest US. banks. Banks may also determine their prime rate based on the prime rate of the Federal Reserve (the Fed) called the federal funds rate.
How Is the Prime Rate Determined?
Banks determine their prime rate using the federal funds rate, also called the federal discount rate, which is the rate that largest banks use to borrow from one another. This rate is set by the federal open market committee (FOMC), which is a branch of the federal reserve bank.
The standard calculation that banks use to determine their current prime rate is to add 3 percent to the federal funds target rate. Prime rates usually don't drop below 3.25 percent, making it the base rate for banks lending to large corporate borrowers.
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