What is the Prime Rate?

The prime rate is the interest rate that a commercial bank charges its best customers. These customers are usually large, stable, and highly creditworthy entities, for which there is a minimal risk of default. A smaller organization can expect to pay several percentage points above the prime rate, since there is a higher risk of default. The rate is also used to adjust the rates charged on adjustable rate mortgages, credit card debt, home equity loans, and student loans.

How is the Prime Rate Derived?

The prime rate is based on the cost of money for banks, which is derived from the federal funds rate, which is set by the Federal Reserve Bank. Thus, if the federal funds rate changes, then so too will the prime rate. The difference between the federal funds rate and the prime rate is usually 3%. For example, if the federal funds rate is 2%, then the prime rate is likely to be about 5%.

There is typically little variation in the prime rates set by the major banks.

Why Does the Prime Rate Change?

Changes in the prime rate are triggered by changes in the interest rate set by the Federal Reserve Board. The Fed sets a higher interest rate when it believes the economy is running too hot, resulting in excessive inflation. This results in a higher cost of money, which should slow down the economy. The Fed will reduce interest rates when the economy appears to be in decline, and needs a supply of cheap money to bolster economic activity.