Prime rate: What is it?

Definition

The prime rate in the US is the interest rate that commercial banks charge their most creditworthy customers for short-term loans.

What is a prime rate?

The prime rate serves as a benchmark for various lending rates throughout the financial system, and is primarily influenced by the federal funds rate, which is set by the Federal Reserve. The Federal Open Market Committee (FOMC) meets regularly to review economic conditions and adjust the federal funds rate as needed. Changes in the federal funds rate often lead to corresponding changes in the prime rate.

The prime rate serves as a reference point for setting interest rates on a variety of loans and credit products offered by banks. Lending rates are typically expressed as a certain percentage above or below the prime rate.

Borrowers who are considered creditworthy by banks may qualify for loans at interest rates close to the prime rate. The margin above the prime rate that a borrower pays depends on factors such as credit history, income, and the type of loan.

The prime rate is widely publicised by financial institutions and media outlets in the US, making it easily accessible to consumers and businesses. This transparency allows borrowers to compare lending rates across different banks and make informed decisions when seeking credit.

Example of a prime rate

Let’s say the prime rate in the US is currently 3.25%. A commercial bank offers a business loan to a highly creditworthy corporation at a rate of prime plus 1.5%, meaning the interest rate on the loan would be calculated as follows:

Prime rate (3.25%) + Margin (1.5%) = Loan interest rate (4.75%)

So, if the prime rate is 3.25% and the bank’s margin is 1.5%, the corporation would be offered the business loan at an interest rate of 4.75%.