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.