What is Prime Rate: How it Works & Formula

The prime rate (aka prime lending rate) is the best interest rate that banks offer the most creditworthy borrowers. Average current prime rates are typically calculated by taking the federal funds rate and adding a 3% margin. Business owners with a strong track record of success and high credit score, known as “prime borrowers,” can qualify for the prime rate.

Current Prime Interest Rate

How the Prime Rate Works

Banks use the prime rate as a starting rate for various financing products, like credit cards, commercial mortgages, small business loans, auto loans, and home loans. Lenders will typically add a margin to the prime rate based on the amount of risk associated with a loan. This is why the best borrowers are called “prime borrowers,” because they qualify for the lowest rate offered by a lender.

The prime rate is influenced by the federal funds rate, which is the interest rate commercial banks charge each other for overnight lending, set by the Federal Reserve Board. The U.S. prime rate is generally determined by adding 3% to the current federal funds rate. This means that the prime rate increases when there’s an increase to the fed rate.

For example, if the federal funds rate is 1%, the prime rate will be calculated as follows:

Prime Rate: 1% + 3% = 4%

Let’s say that your business credit card’s annual percentage rate (APR) is calculated as the prime rate plus a margin of 11%. Based on the example above, the prime rate is 3.25% and the APR for your credit card would be 14.25%. The same calculation is applied to all different financing options, but the margin will be dependent on the specific lender, the financing product, and the associated borrower risk.

This means that not all lenders offer the average prime rate as their actual lowest rate. Therefore, the prime rate is commonly referred to as the lowest rate a lender will offer.

For instance, “prime borrowers” for working capital loans might only receive interest rates as low as 9%. Hard money lenders will often set their lowest rate at 7%. Still, these are derived using the prime rate as a benchmark, and if you qualify for these rates you’re considered a “prime borrower” since they are the lowest offered.

Why is the Prime Rate Important?

The prime rate is one of the most used market indicators and is one of the major factors affecting rates on things like mortgages, business loans, and credit cards. It’s typically used as a benchmark or starting place when calculating interest rates. This means that the range of possible APRs you can qualify for will typically increase or decrease depending on the movement of the prime rate.

The prime rate is typically offered to a lender’s best and most creditworthy clients, which are usually large corporations or business owners with high personal credit scores. Finally, the prime rate is important because it affects liquidity in the financial markets. A low prime rate means loans are less expensive and easier to get, increasing liquidity. Conversely, when prime rates are high, liquidity decreases and it slows down the economy.

Bottom Line: What is the Prime Rate?

As a borrower, it’s important to understand the prime rate because it’s the best interest rate that lenders offer to their most creditworthy clients. The prime rate is usually 3% higher than the federal funds rate. Lenders often add a margin on top of the prime rate to minimize the risk of loan defaults. The added margin is dependent on the specific type of financing product and the lender itself.