Prime Rate

What Is the Prime Rate?

The prime rate is the lowest commercial interest rate charged by banks at a particular time. Banks charge this rate to their preferred customers with the highest credit ratings.

These creditworthy customers are often large corporations that borrow from commercial banks to finance their operations with debt. 

They are eligible for the optimal rate due to their excellent credit rating, Meaning that loaning out funds to these entities entails minimal risk.

In the U.S., the federal funds rate serves as the basis for the prime rate. It is set by the Federal Reserve, the central bank of the United States. It is the interest rate commercial banks charge each other for overnight lending. 

The rate, depending on the economic climate, can change often. It serves as the starting point for most other interest rates. This rate goes up as the Fed raises interest rates and vice versa signifying they are directly correlated.

This rate is usually lower than the interest rates charged to average individuals because they are typically less creditworthy than the banks’ best customers. Therefore, they are more prone to defaulting on a loan.

These rates affect every single entity and level of an economy. They can affect the interest rate on mortgages, credit cards, and many other financial products.

Determining the Prime Rate

In the U.S., these rates closely follow another interest rate set by the Federal Reserve, the Fed target rate. This rate is recalculated by the Federal Open Market Committee eight times per year, or every six weeks, based on the economic climate and market conditions. 

The decision of the Fed to increase or decrease the interest rate solely depends on the U.S. economy. When the economy grows fast, the Fed increases the interest rate to fight against inflation.

The same principle stands when the economy slows down, with the Fed decreasing the interest rate.

Commercial banks might increase their credit if the fed target rate (overnight rate) increases. But, conversely, a sign that could show the economy is slowing down is the creditworthiness of the banks' best customers decreasing.

Nonetheless, three measures are taken to set this rate:

1. First, the Federal Reserve sets the federal target rate based on what it thinks is best for the economy.
2. Banks base the interest rates they charge each other on the federal target rate set.
3. The Wall Street Journal conducts a regular market survey of America's biggest banks to see the interest rate they charge to their "prime" customers and then publishes this rate as the prime rate.

This WSJ prime rate is usually 3 percent higher than the federal fund's target rate.

What Is the Impact of the Prime Rate?

Although this rate is generally given only to the largest corporations with excellent credit scores, it also affects the interest rate imposed on the average person. Therefore, any changes made to this rate would directly affect every other interest rate.

The rate affects the interest rate on every loan, whether it be mortgages or credit cards. In addition, it serves as the starting point for most other interest rates meaning that financial institutions and lenders take the rate into account before imposing a rate on any other form of a loan. 

They generally establish their current rates at an amount higher than the prime rate to account for the larger risk of default. 

For example:

Suppose Jim gets a credit card. After reading the terms set, he learns that the interest he has to pay on the balance is 10%. The bank states, "Prime rate + 6.5%", meaning the prime rate for the year was 3.5%. 

Since Jim is less creditworthy than the bank's best customers, the interest rate is higher.

The rate also affects liquidity in the financial markets. The economy slows down when the rate is high. When it increases, this means it's likely that the creditworthiness of the banks' best customers is decreasing. As a result, liquidity is low, and loans will be more challenging.

Conversely, a low rate increases liquidity and the chances of qualifying for a loan at a cheaper rate. In this context, we witness economic growth as businesses expand.

Summary

To summarize:

• The prime rate is the lowest commercial interest rate charged by banks at a particular time to their most creditworthy customers.
• It is the basis of most other interest rates for mortgages, personal loans, and more.
• It is influenced by the overnight rate set by the Federal Open Market Committee.
• One of the most used prime rate metrics is the Wall Street Journal.

Written and Researched by Jad Shamseddine | Linkedin

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