Prime Rate Definition

What Is the Prime Rate?

The term prime rate refers to the interest rate that commercial banks charge their most creditworthy customers. The Federal Reserve (Fed) sets the federal funds overnight rate which serves as the basis for the prime rate, which is the starting point for other interest rates.

The prime rate (sometimes referred to simply as "prime") is the most commonly used benchmark used by banks and other lenders when setting their interest rates for various products, such as credit cards and home loans.

How the Prime Rate Works

Interest rates are a percentage of the amount that lenders charge on any loans they grant to borrowers. It acts as a form of compensation for the risk that lenders assume based on the borrower’s credit history and other financial details. These rates are normally noted annually as the annual percentage rate (APR).

The prime rate is the interest rate that commercial banks charge their most creditworthy customers, generally large corporations. The prime interest rate, which is also called the prime lending rate, is largely determined by the federal funds rate set by the Federal Open Market Committee (FOMC).The fed funds rate is the overnight rate that banks use to lend to one another. Banks commonly use a combination of the federal funds rate + 3 to determine the prime rate.

As noted above, lenders charge their most creditworthy clients the prime rate for mortgages, small business loans, or personal loans. For others, the prime rate forms the basis or starting point for most other interest rates. The interest these borrowers are charged, which is based on their credit scores and credit histories, is normally prime plus a certain percentage. Those who have a good credit score would be charged, say, prime plus 9% for a credit card while those with a lower score may get a rate of prime plus 15%.

Determining the Prime Rate

The prime rate is an interest rate determined by individual banks and used as a base rate for many types of loans, including loans to small businesses and credit cards. Although the Federal Reserve has no direct role in setting the prime rate for banks, many financial institutions choose to set their prime rates based partly on the target level of the federal funds rate established by the FOMC.

One of the most used prime rates is the one that the Wall Street Journal publishes daily. As noted above, banks generally use fed funds + 3 to determine the current prime rate. The prime rate in the United States was 7.75% as of February 2023. That's an increase from 7.5%, which was the rate set in December 2022. The increase occurred at the same time that the Fed raised its fed funds rate range to 4.5% to 4.75% in February 2023.

Although other U.S. financial services institutions regularly note any changes that the Fed makes to its prime rate, and may use them to justify changes to their prime rates, institutions are not required to raise their prime rates following the Fed.

What Is the Impact of the Prime Rate?

The prime rate affects a variety of bank loans. When the prime rate goes up, so does the cost to access small business loans, lines of credit (LOCs), car loans, mortgages, and credit card interest rates.

Debt with a variable interest rate can be affected by the prime rate because a bank can change your rate. This includes credit cards as well as variable rate mortgages, home equity loans, personal loans, and variable interest rate student loans.

The prime rate is reserved for only the most qualified customers, those who pose the least amount of default risk. Prime rates may not be available to individual borrowers but are offered to larger entities, such as corporations and stable businesses. If the prime rate is set at 5%, a lender still may offer rates below 5% to well-qualified customers which are not considered a mandatory minimum.

How Does the Prime Rate Affect Borrowers?

The prime rate is not fixed and can change over time based on changes in the federal funds rate, inflation, the demand for loans, and other economic factors. When the prime rate changes, the interest rates on loans and financial products that are based on the prime rate may also change.

The prime rate can affect you in a number of ways, depending on the type of loan or financial product you have.

1. Home equity loans. If a borrower has a home equity loan or home equity line of credit (HELOC), the interest rate on the loan may be based on the prime rate. If the prime rate increases, the interest rate on the home equity loan may also increase, leading to higher monthly payments for the borrower.
2. Adjustable-rate mortgages (ARMs). If a borrower has an ARM that is tied to the prime rate, an increase in the prime rate may lead to an increase in the interest rate on the mortgage, resulting in higher monthly payments for the borrower.
3. Credit card balances. If a borrower has a credit card with a variable interest rate, the interest rate may be based on the prime rate. If the prime rate increases, the interest rate on the credit card may also increase, leading to higher interest charges for the borrower.
4. Small business loans. If a small business has a loan with an interest rate based on the prime rate, an increase in the prime rate may lead to an increase in the interest rate on the loan, resulting in higher loan payments for the business.

History of the Prime Rate

The prime rate has a long history dating back to the 1930s century when it was first used by banks to set the interest rates for short-term lending to their most creditworthy customers following the Great Depression. In the decades following World War II, the prime rate remained relatively stable, hovering around 2% to 3%.

However, in the 1970s, the prime rate began to rise significantly as the United States experienced an economic recession and high inflation. The prime rate reached its all-time high of 21.5% in December 1980, as the Federal Reserve sought to curb inflation by raising interest rates.

Over the next few decades, the prime rate fluctuated widely, reflecting the ups and downs of the economy and largely mirroring other benchmark interest rates. During times of economic growth, the prime rate tends to be higher, while it tends to be lower during times of recession or financial turmoil.

The Bottom Line

The prime rate is the interest rate that commercial banks charge creditworthy customers and is based on the Federal Reserve's federal funds overnight rate. Banks generally use a fed funds + 3 to determine the current prime rate. The rate forms the basis for other interest rates, including rates for mortgages, small business loans, or personal loans.