The prime rate is used as the index for rates offered in consumer lending and loan products. When government central banks purchase securities back from private banks in exchange for cash, the repo rate is used. "Repo" is a shortened form of the term "repossession" and indicates a repurchase of securities by the government that previously sold them. The repo rate system allows governments to control money supplies within economies by increasing or decreasing available funds. Prime rates and repo rates are both set by central banks.
The Difference Between the Prime Rate and the Repo Rate
Mortgages, credit cards and other consumer loan interest rates are calculated based on the prime rate. In the United States, this rate is the same for all states and applies to all consumer loans offered by private banks. Banking institutions add profit margins to the prime rate to determine the actual rates customers are charged for loans. A decrease in the prime rate encourages more consumers to borrow money by making borrowing cheaper. Increases in the rate, however, raise the cost of consumer loans unless banks reduce their profit margins enough to make up the difference. For example, a loan based on a prime rate of 2.5% and a profit margin of 2.5% would have an overall interest rate of 5% for the consumer. If the prime rate drops to 1.5% but the profit margin remains the same, the total interest rate falls to 4%.
A decrease in repo rates encourages banks to sell securities back to the government in return for cash. This increases the money supply available to the general economy. By increasing repo rates, central banks may decrease the money supply by discouraging banks from reselling these securities.