A:

Although the prime rate and the federal funds rate are closely tied to one another, their base rates differ based on market regulations set by the Federal Reserve. The prime rate is the interest rate that banks charge consumers for loans, such as credit cards and mortgages. Its fluctuations follow the federal funds rate, which is the rate that banks charge one another for overnight loans. The prime rate generally runs a few points above the federal funds rate, and banks normally reserve this rate for their most creditworthy customers.

For example, a credit card company's customers with high credit ratings may receive the prime interest rate. If the federal funds rate is 2%, then the prime rate would be approximately 5%, as it runs about 3 points above the federal funds rate. If the federal funds rate gets lowered from 2% to 1.5%, the bank may lower the interest rate on the credit card accordingly.

The federal funds rate has a direct effect on the U.S. economy, as it serves as a base rate for all other interest rates offered by various financial institutions and organizations. Generally, the higher the federal funds rate, the more expensive it is for anyone to borrow money.

Regulations set by the Federal Reserve call for financial institutions to maintain a certain amount of reserve funds in their Federal Reserve account each day. If a bank expects a shortfall at the end of a business day, another institution that has a surplus for that day may step in and loan funds to the bank. The interest rate that the loaning bank charges for the money is the federal funds overnight rate.

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