Loading the player...

What is the 'Prime Rate'

The prime rate is the interest rate that commercial banks charge their most credit-worthy customers. Generally, a bank's best customers consist of large corporations. The prime interest rate, or prime lending rate, is largely determined by the federal funds rate, which is the overnight rate that banks use to lend to one another; the prime rate is also important for individual borrowers, as the prime rate directly affects the lending rates available for a mortgage, small business loan or personal loan.

BREAKING DOWN 'Prime Rate'

Default risk is the main determiner of the interest rate a bank charges a borrower. Because a bank's best customers have little chance of defaulting, the bank can charge them a rate that is lower than the rate charged to a customer who has a higher likelihood of defaulting on a loan.

The prime rate serves as a basis, or point of reference, for determining most other interest rates lenders make available to borrowers, even though it might not be specifically listed as a component of the rate ultimately charged. Interest rates serve as compensation for the risk taken on by the lender based on the borrower’s credit history and other financial details, and provide a way to cover costs associated with lending.

Prime Rates and Variable Interest Rates

In cases of variable interest rates, such as those used on certain credit cards, the card’s interest rate may be expressed as the prime rate plus a set percentage. This means the rate rises and falls with the prime rate but always remains a fixed percentage above the prime rate at all times.

Determining the Prime Rate

The prime rate is not set by a particular legal entity, and the prime rate used by one institution may be different than the prime rate in use by another. While changes to the Federal Reserve’s prime rate are commonly noted by other U.S. institutions, and may be used to justify changes in the institution’s prime rate, it is not a requirement for the institution to raise its prime rate accordingly.

Prime Rate and Best-Qualified Customers

Generally, the prime rate is reserved for only the most qualified customers, determined as those who pose the least amount of risk of default. Prime rates may not be available to individual borrowers as often as to larger entities, such as particularly stable businesses.

Even if the prime rate is set at a particular percentage, such as 5%, that does not mean a lender cannot offer rates below that amount to well-qualified customers. The prime rate is considered a benchmark only, and though it is likely to be the lowest announced rate available, it should not be considered a mandatory minimum.

RELATED TERMS
  1. Bank Rate

    The interest rate at which a nation's central bank lends money ...
  2. Prime Cost

    A business's expenses for the materials and labor it uses in ...
  3. Key Rate

    The specific interest rate that determines bank lending rates ...
  4. Prime Borrower

    A prime borrower is considered likely to make loan payments on ...
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds ...
  6. Prime Brokerage

    A special group of services that many brokerages give to special ...
Related Articles
  1. Personal Finance

    Explaining Prime Rate

    Prime rate is the interest rate banks charge their best (e.g. prime) customers.
  2. Trading

    How Interest Rate Cuts Affect Consumers

    Stock traders usually rejoice when the Federal Reserve cuts interest rates. But it’s not always best for everyone.
  3. Insights

    What Is The Relationship Between The Federal Funds, Prime And LIBOR Rates?

    The prime rate and LIBOR rate, two of the most prominent benchmark rates, tend to track the federal funds rate closely over time. However, during periods of economic turmoil, LIBOR appears more ...
  4. Insights

    The Impact of the Fed Interest Rate Hike

    The Federal Reserve recently raised benchmark interest rates. With much attention on the Fed's policy, here's what happens when the Fed hikes rates.
  5. Personal Finance

    How Interest Rate Cuts Affect Consumers

    Traders rejoice when the Fed drops the rate, but is it good news for all? Find out here.
  6. Personal Finance

    How Banks Set Interest Rates on Your Loans

    Many factors go into how banks set interest rates for loans. Use this information to negotiate the best possible rate when you're borrowing.
  7. Investing

    Forces Behind Interest Rates

    Interest is a cost for one party, and income for another. Regardless of the perspective, interest rates are always changing.
  8. Personal Finance

    The Role of a Prime Broker

    Understand the role of a prime brokerage, and learn about the services investment banks provide for hedge funds while in the role of being a prime broker.
  9. Investing

    How Do Interest Rates Affect the Stock Market?

    Interest rates can have a complicated ripple effect through financial markets. Here's what you need to know.
  10. Insights

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
RELATED FAQS
  1. What should ordinary borrowers know about the prime rate?

    Learn more about how prime rates are used in consumer lending and how consumers may obtain better interest rates at or near ... Read Answer >>
  2. Is the prime rate in the US different from the federal funds rate?

    Learn how the federal funds rate affects fluctuations in the prime rate and how following your bank's prime rate can help ... Read Answer >>
  3. How does the Wall Street Journal prime rate forecast work?

    Learn about the Wall Street Journal's prime interest rate methodology. Discover trailing financial indicators, and engage ... Read Answer >>
  4. What are the most important interest rates?

    Learn about the most important interest rates in the economy; the Federal funds rate and discount rate are set by the Federal ... Read Answer >>
  5. What's the difference between the prime rate and the repo rate?

    Learn about repo rates and prime rates and their differences. Explore the uses of these rates in consumer lending and managing ... Read Answer >>
  6. How does the equity risk premium correlate with the Federal Reserve's prime rate?

    Learn about how the equity risk premium correlates with the Federal Reserve's prime rate. The Fed adjusts the prime rate ... Read Answer >>
Hot Definitions
  1. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  2. Down Round

    A round of financing where investors purchase stock from a company at a lower valuation than the valuation placed upon the ...
  3. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  4. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment is made with the expectation of earning a return on it. This ...
  5. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless ...
  6. Buyback

    The repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies ...
Trading Center