What Is the Prime Rate: How it Works, Definition & Formula

The prime rate is an interest rate set by banks representing the lowest interest rate at which a bank will lend money to its most creditworthy borrowers. It is highly correlated to the Federal Funds Target Rate set by the Federal Reserve. The current prime rate, published by the Wall Street Journal, is 3.25%.

Current Prime Interest Rate

How the Prime Rate Works

The prime rate is used by banks as a benchmark for setting interest rates on various financing products, such as loans and lines of credit. Most traditional lending product interest rates are derived by taking the prime rate and adding a margin, known as the spread, based on the creditworthiness of the borrower and the amount of risk associated with the loan.

Any bank may choose to issue its own prime rate. Many smaller banks will determine the prime rate by pegging to a larger institution’s rate. Many banks use a generally accepted prime rate known as the WSJ Prime, available from the Wall Street Journal, which is determined by polling 10 of the largest United States banks and taking the average.

How the Prime Rate Is Calculated

The prime rate is loosely based on the Federal Funds Target Rate, which is also known as the fed funds rate or the overnight rate. This rate is set by the Federal Reserve and is the rate at which large commercial banks can borrow money overnight. Traditionally, the prime rate is equal to the Federal Funds Target Rate plus 3%. So, if the current target rate is 1.75%, then the prime rate is 4.75%.

The effective floor for the prime rate is 3.25%, meaning if the fed funds rate drops below 0.25%, the prime rate will stagnate. This effective floor was seen recently during the recession triggered by the housing market crash in 2007. To trigger growth in the wake of the housing market crash, the Fed set the overnight target rate at 0%.

How Fed Rates Influence Prime Rate

The fed funds rate is a rate set by the Federal Reserve that dictates the interest rate at which banks can borrow from other banks. This rate is often referred to as the overnight rate. The Federal Reserve is often referred to as the “banker’s bank” and is the central bank of the United States. Banks use the overnight rate as a benchmark to which the prime rate margin is applied.

When the Prime Rate Is Used

The prime rate is used across debt-based products offered by traditional banking establishments as a basis for rates as well as in many cases by alternative lenders. Many forms of consumer debt are impacted by the prime rate, such as credit cards and lines of credit.

The prime rate is used as a base rate to which a margin is added, known as the spread, based on both the creditworthiness of the borrower as well as the risk represented by the type of debt. For example, the spread for a variable rate credit card might be anywhere between 4% to 15%, whereas the spread on an SBA 7(a) loan―set by the Small Business Administration―is much lower.

Why the Prime Rate Matters

Because the prime rate is tied to the fed funds rate, it is largely immune to market manipulation, allowing banks a benchmark for determining the lowest rates. Without the Federal Reserve setting the tone for interest rates, the currency could become difficult to borrow. Conversely, banks might overcomplete on interest rates, contributing to inflation.

For most of us, the prime rate matters because it is tied to so many consumer and business lending products, such as home equity lines of credit, credit cards, loan rates, and more. When the prime rate is adjusted, the corresponding interest rates on all of these products move along with it. Paying attention to the prime rate can help make borrowing decisions easier.

Who Qualifies for the Prime Rate

When consumers first hear about the prime rate, a question that naturally occurs is “who qualifies for this?” The answer is: usually not regular consumers. While the prime rate represents the lowest rate a bank is willing to charge its most creditworthy borrowers, this designation is typically reserved for large corporations with a high credit rating.

In contrast to these corporations, a consumer with a perfect credit score still represents a higher risk of default. Instead, consumers and small business borrowers will find that they qualify for a rate based on prime, plus a spread based on their individual creditworthiness and the risk represented by the lending product.

Prime Rate vs Home Mortgage Rate

Many believe the home mortgage rate is linked to the prime rate. In reality, there is very little connection between the two. While home equity lines of credit and credit cards are typically tied to the prime rate, home mortgage interest rates are based on the bond market and other marketplace factors.

When a lender originates a mortgage, it is packaged up into mortgage-backed securities (MBS), which are then sold on the bonds market. Because MBS are sold on the same market and typically to the same investors as 10-year Treasury Bonds, it is often thought that 10-year Treasury bonds and MBS are linked. However, they are distinct rates, and the link is casual.

Prime Rate Examples

Many financial products use the prime rate as a benchmark rate to which a spread, or margin, is added to make up the fixed or variable interest rate. To better understand how the prime rate influences borrowing, we can look at some examples. For the sake of this example, let’s say that the prime rate is currently at 4.75%.

Prime Rate Examples

Sources: St Louis Fed, fitsmallbusiness.com.

Alternatives to the Prime Rate

While most banks use the prime rate in the U.S. as the benchmark against which rates are set, banks are not required to use the prime rate. Some banks, primarily establishments with a large number of international clients, use the London Inter-bank Offered Rate, or Libor, instead.

The Prime Rate vs Libor

The Libor is a global benchmark rate used by banking institutions worldwide. It’s important to note the Libor is not interchangeable with the prime rate and is instead more closely related to the fed funds rate, as it is the rate at which banks lend each other funds. It is used similarly to the prime rate as a benchmark rate off of which banks charge their customers interest.

Libor is typically favored by banks not based in the U.S. with a large number of clients outside the U.S. There are indications that the Libor may be phased out by 2021 in favor of a new benchmark known as the secured overnight financing rate.

History of the Prime Rate

The prime rate was in a growth cycle following the housing market crash and global market recession in 2008, when the prime rate hit its theoretical floor of 3.25%. At that time, the Fed had cut the fed funds rate to 0.25%, or essentially 0%. Since then, that rate has gradually climbed up, with the prime rate moving in sync. Growth halted recently, when on August 1, 2019, the Fed lowered the target rate by 0.25% to 2.00 to 2.25%, followed shortly after by a drop to 1.75% to 2.00% on September 19, 2019.

Is the Prime Rate Historically Low

Although the prime rate is not at a historical low, it is still lower than average, which is slightly less than 10% since 1955. In December 1980, the prime rate had climbed to 21.50%, its highest point in history. At the time, the Federal Reserve was engaged in an active campaign to arrest inflation. In June 2006, prior to the global recession, the prime rate was at its highest during the last 15 years, at 8.25%.

Source: Federal Reserve Bank of St. Louis

Bottom Line

While many believe the prime rate is set at the federal level, it is instead loosely based on the Federal Reserve federal funds rate. A common measurement of the prime rate, the WSJ prime is determined by polling 10 leading U.S. banking institutions. While not at its lowest point in history, the prime rate is at near historic lows, meaning the costs to borrow are near historic lows as well.