What is the Prime Rate?
The prime rate is the interest rate that commercial banks charge their most creditworthy customers. Generally, a bank's best customers consist of large corporations. The prime interest rate, or prime lending rate, is largely determined by the federal funds rate, which is the overnight rate that banks use to lend to one another. The prime rate is also important for individual borrowers, as the prime rate directly affects the lending rates available for a mortgage, small business loan or personal loan.
Breaking Down Prime Rate
Default risk is the main determiner of the interest rate a bank charges a borrower. 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 likelihood of defaulting on a loan.
The prime rate serves as a basis, or point of reference, for determining most other interest rates lenders make available to borrowers, even though it might not be specifically listed as a component of the rate ultimately charged. Interest rates serve as compensation for the risk taken on by the lender based on the borrower’s credit history and other financial details and provide a way to cover costs associated with lending.
Prime Rates and Variable Interest Rates
In cases of variable interest rates, such as those used on certain credit cards, the card’s interest rate may be expressed as the prime rate plus a set percentage. This means the rate rises and falls with the prime rate but always remains a fixed percentage above the prime rate at all times.
Determining the Prime Rate
The prime rate is not set by a particular legal entity, and the prime rate used by one institution may be different from the prime rate in use by another institution. While changes to the Federal Reserve’s prime rate are commonly noted by other U.S. institutions, and may be used to justify changes in the institution’s prime rate, it is not a requirement for the institution to raise its prime rate accordingly.
Prime Rate and Best-Qualified Customers
Generally, the prime rate is reserved for only the most qualified customers, determined as those who pose the least amount of risk of default. Prime rates may not be available to individual borrowers as often as to larger entities, such as particularly stable businesses.
Even if the prime rate is set at a particular percentage, such as 5%, that does not mean a lender cannot offer rates below that amount to well-qualified customers. The prime rate is considered a benchmark only, and though it is likely to be the lowest announced rate available, it should not be considered a mandatory minimum.