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?

There are a number of underlying reasons for changes in the prime rate, of which the following are the most common:

Inflation rates. High inflation leads to higher interest rates, including the prime rate, as banks compensate for the decreasing value of money. If inflation is low, the Fed may lower rates, causing a drop in the prime rate.
Economic growth and stability. In a strong economy, businesses and consumers borrow more, increasing demand for loans. Banks may raise the prime rate to capitalize on this demand.
Banking competition. Banks compete for customers by adjusting their lending rates. If one major bank lowers its prime rate, others may follow to stay competitive.
Monetary policy. The Federal Reserve influences the prime rate through monetary policy tools, such as open market operations and reserve requirements. Tight monetary policy (reducing money supply) raises interest rates, thereby increasing the prime rate. Conversely, loose monetary policy (increasing money supply) lowers the prime rate.
Credit market conditions. If banks have limited liquidity (less money to lend), they increase the prime rate to manage risk and improve their profitability. Or, if banks have excess reserves, they may lower the prime rate to encourage more borrowing.
Government debt. If government debt levels rise, treasury yields (interest rates on government bonds) may increase. Higher treasury yields can push banks to raise the prime rate to maintain competitive lending margins.
Global events. Events such as wars, trade conflicts, or pandemics can affect financial markets and interest rates. Economic uncertainty may cause banks to increase the prime rate to compensate for higher risks.

In short, the prime rate is influenced by a mix of monetary policy, economic conditions, inflation, banking competition, and global events. While the Federal Reserve’s federal funds rate is the biggest driver, banks also consider their own financial health and market dynamics when setting the prime rate.