Prime Rate vs. Discount Rate: An Overview
The Federal Reserve Bank (the Fed) sets both the prime rate (prime) and the discount rate. The prime interest rate—which the Wall Street Journal publishes—plays an important role in determining the lending rates that many banks and other lenders charge for consumer loan products. As a federal interest rate, prime does not vary from state to state. Prime is a short-term rate, but not as short term as the discount rate, which typically is an overnight lending rate.
The Fed sets and offers the discount rate to member banks and thrifts that need to borrow money in order to prevent their reserves from dipping below the legally required minimum. When banks within the U.S. banking system loan to each other, they use the discount rate. The discount rate is not usually publicized in a general publication; rather, it's an internal figure.
To determine their consumer interest rates, banks add a margin to the prime rate, which especially affects borrowers whose loans have variable-rate APRs.
Generally, the prime rate is reserved for banks' most qualified customers—those who pose the least potential for default risk. Prime rates may not be available to individual borrowers as often as to large corporate entities. 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 probability of defaulting on a loan.
Prime as a benchmark
As an index, prime is used as a benchmark for all types of consumer loans. When calculating consumer interest rates, commercial banks add a margin to the prime rate. Products, such as home equity lines of credit (HELOCs), mortgages, student loans, and personal loans all have customized interest rates that take borrower creditworthiness into consideration. For example, if the prime rate is 2.75% and the bank adds a margin of 2.25% to a HELOC, then the interest rate for that loan is 5% (2.75% plus 2.25%).
Prime's effect on APRs
In particular, the prime rate will have a great impact on consumers whose mortgage or credit card loans have adjustable interest rates. For example, if your credit card has a variable annual percentage rate (APR) that changes with the prime rate, your rate will fluctuate along with the prime rate. If the prime rate goes up, variable APRs likely will, too. In contrast, the discount rate is not an index, so banks use the set federal funds rate, without adding a margin, for loans that they make to each other.
Depending on the context, the discount rate has two definitions and uses. First, the discount rate refers to the interest rate that the Federal Reserve offers to commercial banks and other financial institutions. Second, the discount rate refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows.
The Fed charges the discount rate to other banks and financial institutions for their short-term operating needs; they use the loaned capital to fund any shortfalls, prevent potential liquidity problems or, in the worst-case scenario, to avert a bank’s failure. Such loans are served by the 12 regional branches of the Fed, which grants this special lending facility for an ultra-short period of 24-hours or less, known as the discount window. The discount rate is not a market rate, rather it is administered and set by the boards of the Federal Reserve Bank and is approved by its Board of Governors.
- The Federal Reserve Bank sets both the prime and the discount rates; it meets regularly to review and potentially change them.
- Banks base consumer loans—like mortgages and credit cards—on the prime rate, to which they generally add a margin.
- The discount rate is an internal (non-public) figure, which financial institutions use when lending to each other.
Interest Rates and the Fed
The prime rate and the discount rate significantly affect the consumer loan and banking industries and drive the cost of borrowing. By adjusting interest rates, the Federal Reserve's tight rein of the money supply helps to control inflation and avoid recessions.
For example, the Fed may decide to charge a higher discount rate to discourage banks from borrowing money, which would effectively reduce the amount of money available for consumer and business loans. Or, the Fed may lower discount rates to encourage banks to offer more loans. In general, the Fed will intervene to change rates when it needs to send a cash influx into the economy or to pull some money out of circulation. The Federal Open Market Committee (FOMC) meets at least eight times a year to review and possibly change these rates.
Prime vs. Discount Rate: Summary of Key Differences
Although the prime rate and discount rate have several similarities, they also have some key differences. It is important for businesses and consumers alike to understand how these two rates ultimately affect the interest they pay on interbank loans, mortgages, and credit cards.
- Prime is a benchmark, for various other loans. As such, lenders add a margin to the prime rate to arrive at the rate for consumers.
- The discount rate is not an index, so for loans that they make to each other banks use the federal funds rate, without adding a margin.
- The prime rate is a short-term rate; but not as short as the discount rate, which is typically an overnight lending rate.
- The prime rate is a federal interest rate; it does not vary from state to state and is published in the Wall Street Journal.
- The discount rate is not publicized in a general publication. Rather, it's an internal figure used in the U.S. banking system.
A Symbiotic Relationship
As a rule of thumb, the prime rate always adjusts based on how the Fed moves the discount rate. When the discount rate goes up, the prime rate goes up as well—producing higher mortgage interest rates—which can slow the demand for new loans and cool the housing market. The opposite is also true. If the Fed lowers the discount rate, the prime rate will come down and mortgage interest rates may dip to more favorable levels, which could boost a slumping housing market. The two rates tend to correlate over time (but not as strongly as with the 10-year bond yield, because of its longer maturity).