What Does Prime Mean?
Prime is a classification of borrowers, rates, or holdings in the lending market that are considered to be of high quality. This classification often refers to loans made to high quality prime borrowers that are offered prime or relatively low interest rates.
- Prime is a term that refers to high quality in the lending market.
- Prime is typically associated with borrowers, loans, and/or rates.
- Characteristics of prime lending can include low default risk, high credit scores, and extremely low interest rates.
Within the credit market, prime generally refers to aspects of high-quality lending. Prime loans are considered to be one of the lowest risk loan groups a lender holds on its balance sheet. Prime loans are also typically the easiest to sell on the secondary market.
Prime borrowers have high credit scores and low relative default risks which earn prime rates from lenders. Securitized credit products comprised heavily of prime loans can also obtain several advantages.
A major variable in the determination of prime borrowers is their credit score. Lenders usually obtain credit scoring details based on FICO scoring methodologies. FICO scores can range from 300 to 850 with borrowers above 620 generally considered to be prime borrowers, eligible for prime loans. Borrowers with a nearly perfect 750 to 850 score can also be tagged as super-prime borrowers.
When considering a potential loan, lenders have sophisticated systems in place for loan applications and credit underwriting. A borrower’s credit score usually determines the terms they are eligible for receiving. Other detailed variables can also be considered in the underwriting process including a borrower’s debt-to-income and total credit profile. Borrowers with a high quality credit profile may be able to gain prime rate loans even with an average credit score in some cases. Generally, assigned terms of a loan will vary by each lender.
Prime borrowers can be more selective in the types of credit they take on since they are clients highly sought out by lenders. Prime borrowers can expect to receive a lender’s lowest interest rate. They will also often be approved for larger amounts of financing due to their high credit quality status.
Alternatively, subprime borrowers are those generally with credit scores below 620. These borrowers will be required to pay higher interest rates. They may also be required to resort to much lower quality credit offerings like those with high fees, high rates, and low balances.
Lenders categorize loans issued by a variety of categories for risk management purposes. Prime loans offer the lowest risk to lenders and are typically issued by traditional financial institutions that manage a variety of credit products on their balance sheet.
Following the financial crisis and subsequent Dodd Frank Act, lenders in the financial industry have been required to increase the quality of loans they approve for origination. Dodd Frank implemented a number of provisions governing the credit underwriting standards specifically for banks. The Act also introduced qualified mortgages which are mortgages that meet certain requirements acceptable for special protections. As a result of the improved lending standards, the percentage of high-quality mortgages has increased, which has also helped to improve confidence in the economic stability of the economy.
Due to an active secondary loan market in the credit industry, lenders also have the opportunity to sell loans in the open market or sell them for securitization. Prime loans are often some of the most profitable loans for sale. In the mortgage market, prime loan classification is also often a key characteristic for secondary market structured portfolios sold to government supported agencies, including Ginnie Mae, Freddie Mac, and Fannie Mae.
The prime rate is another component of top-quality lending. While low rates may generally be referred to as prime, there is also a prime rate quoted for several benchmark referencing purposes.
Within the credit market, rates follow a tiered schedule with the federal funds rate being the lowest, followed by the discount rate, and then a prime rate. The federal funds rate is set by the Federal Reserve Open Market Committee which is highly publicized. The federal funds rate is a very short-term rate used for lending among the Federal Reserve banks. The discount rate is slightly higher than the federal funds rate. It is also set by the Federal Reserve. The discount rate is used for Federal Reserve bank lending to commercial banks. The prime rate is slightly higher than the discount rate. The prime rate is a rate offered by banks for their highest quality borrowers, usually in the super-prime category.
The prime rate can be harder to pinpoint than the federal funds rate and discount rate. One of the best proxies for the prime rate is the Wall Street Journal’s prime rate quote. This quote is an average of the prime rates at the 10 largest banks in the United States. Since rates are generally on a tiered schedule based on the types of risks involved, a change in the federal funds rate will usually have some marginal effect on all borrowing rates overall with the discount rate and prime rate being the most directly affected.