Prime Rate

What Is The Prime Rate?

The prime rate is the interest rate that commercial banks charge customers with the highest credit ratings.

Deeper Definition

When customers apply for loans from banks, banks charge them interest based on the risk the customer poses. Customers with a prime credit score (usually 660 and above) are more likely to receive favorable terms.

The prime rate is the interest rate banks charge their most creditworthy customers. It is determined mainly by the federal funds rate. The federal funds rate is the interest rate at which banks and credit unions lend their reserve or surplus balances to other financial institutions overnight.

It is the most favorable or lowest interest rate. It is available only to creditworthy customers because banks believe that the likelihood of them defaulting is low. Interest rates cover the cost associated with lending and serve as compensation for the risk a Bank is taking by lending its money out.

Each bank sets its own rate and uses it as a basis to set the interest rates of various types of loans and lines of credit. Usually, they express the loans as prime plus a certain percentage. 

Prime Rate Example

Mabel is considering getting a credit card. While reading the terms and conditions, she discovers that the annual percentage rate she will have to pay is 14%, which is “Prime + 10.25” according to the bank. It means the prime rate that year is 3.75%. Since Mabel is a new customer and has not established her creditworthiness, the bank believes lending her money is risky.

It tends to fluctuate based on changes in the economy. In the above illustration, the rate was 3.75% at the time Mabel applied. Weeks or months later, the rate most likely wouldn’t be the same, depending on the economic situation.