A:

Both the prime rate and discount rate are used in the financial system and set in the United States by the Federal Reserve Bank. The discount rate is used when the Federal Reserve makes a loan to a private bank or when commercial banks lend to each other. The prime rate, however, is the index that is used when consumer loan product rates are determined. These two rates make a significant impact on banking and consumer loans and drive the cost of borrowing. The Federal Reserve, by adjusting interest rates, controls the money supply and influences the U.S. economy.

The prime rate, as an index, is the rate at which a borrower with an ideal credit rating and creditworthiness borrows money. Banks set their own rates and add them to the prime rate when calculating consumer interest rates. Loan products, such as mortgages, student loans and personal loans, all have customized interest rates that take borrower creditworthiness into consideration. Decreases in the prime rate typically encourage more borrowing as long as bank charges remain the same or decrease.

Discount rates determine how much banks pay when they borrow money, and changing this rate controls the amount of money available in the economy at a given time. The Federal Reserve may decide to charge a higher discount rate, discouraging banks from borrowing money. This effectively reduces the amount of money available for consumer and business loans. Lower discount rates, however, can be used to encourage banks to offer more loans.

RELATED FAQS
  1. How does a high discount rate affect the economy?

    When the Federal Reserve sets a high discount rate, loans are more expensive and borrowers have to work to pay off loans ... Read Answer >>
  2. What are the implications of a low federal funds rate?

    Find out what a low federal funds rate means for the economy. Discover the effects of monetary policy and how it can impact ... Read Answer >>
  3. Why do commercial banks borrow from the Federal Reserve?

    Commercial banks borrow from the Federal Reserve primarily to meet reserve requirements when their cash on hand is low before ... Read Answer >>
  4. What are some examples of expansionary monetary policy?

    Learn about expansionary monetary policy and how central banks use discount rates, reserve ratios and purchases of securities ... Read Answer >>
Related Articles
  1. Insights

    The Impact of a Fed Interest Rate Hike

    When interest rates increase, there are effects on the ways that consumers and businesses can access credit and plan their finances.
  2. Trading

    How To Borrow For Free

    People will do anything to get a little extra money. If you need some cash, here are some ways you can borrow without much hassle.
  3. Investing

    How the Federal Reserve Devises Monetary Policy

    Learn about the tools the Federal Reserve uses to influence interest rates and economic conditions. Find out the types of action a central bank may take.
  4. Personal Finance

    How the Federal Reserve Affects Your Mortgage

    The Federal Reserve can impact the cost of funds for banks and consequently for mortgage borrowers when maintaining economic stability.
  5. Insights

    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.
  6. Personal Finance

    Different needs, different loans

    When it comes to loans, there are many different types according to your needs. Find out what options are available when it comes to borrowing money.
  7. Personal Finance

    Bank Profitability in the Era of Low Interest Rates

    The "low-for-long" policy on interest rates presents a major challenge to bank profitability.
  8. Personal Finance

    The Best Way to Borrow

    There are many ways to secure funding. Find out the pros and cons of each way to borrow.
  9. Financial Advisor

    How Federal Reserve Activity Impacts Investment Portfolios

    The Federal Reserve's monetary policies impact investments in a number of ways.
RELATED TERMS
  1. Reference Rate

    A reference rate uses benchmarks, like the prime rate and the ...
  2. Federal Reserve Credit

    Federal Reserve Credit refers to the Federal Reserve lending ...
  3. Interest Rate

    Interest rate is the amount charged, expressed as a percentage ...
  4. Fixed Interest Rate

    A fixed interest rate is an interest rate on a liability, such ...
  5. Initial Interest Rate

    Initial interest rate is the introductory rate on an adjustable ...
  6. Discount Window

    Discount window is a central bank lending facility meant to help ...
Trading Center