The prime interest rate is what banks charge their best and most creditworthy customers. Also known as the prime lending rate, it is based on the Federal Reserve’s decision to raise or lower prevailing interest rates for short-term borrowing. Although some banks will charge their best customers more and some less than the official prime rate, the rate is used as the standard in the banking industry when a bank changes its prime rate up or down. The rate is a key interest rate, since loans to less-creditworthy customers are often tied to the prime rate and it is usually the best loan rate available to non-banks and individuals as well. For consumers, this means only those borrowers with good credit histories will qualify for the prime interest rate.
The prime interest rate affects the financial markets because when prime lending rates are low, businesses expand along with the overall economy. Low rates increase liquidity because they make loans less expensive and easier to obtain. Conversely, when the prime lending rate is high, liquidity shrinks and the overall economy begins to slow. This means that most banks will only raise the prime interest rate when the Federal Reserve Funds rate is increased. Various consumer loans, like home equity, automobile, mortgage, and credit card loans, are all usually tied to the prime rate. However, even though the prime rate is considered the best rate, some banks employ a system that allows companies with excellent credit standing to borrow at even lower rates than prime.
The prime rate does not vary much among different banks, and any adjustments are usually made by all banks at the same time. The prime rate is normally 3 percentage points above the Federal Funds rate, making it the rate that banks typically charge each other for short overnight loans needed to fulfill their reserve funding requirements. The most creditworthy borrowers can sometimes get loans at the Federal Funds rate plus a smaller percentage point charge. In the past, when 23 out of 30 of the United States' largest banks would act to change their prime rate, the Wall Street Journal would publish the new rate. In 2008 the Wall Street Journal changed the system of publishing the national the prime rate, and now it reflects only the base rate listed by seven out of the top ten banks as ranked by their total assets.
Today, the prime rate is most often used as an index for calculating any rate changes for adjustable rate mortgages and other short term loans with variable rates. The prime rate is now also used in the calculation of private student loans and many credit card and home equity lines of credit that employ variable interest rates as well. On these types of variable rate loans, the interest rates are usually listed as the prime rate plus an additional fixed value that is also called the spread or margin rate.
