This article is part of a larger series on Business Financing.
The prime rate is used as a base rate by banks to which an additional percentage of interest is added based on both the creditworthiness of the borrower and the risk represented by the type of debt. It’s used for loans offered by banks and, in many cases, by alternative lenders. 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. Traditionally, the prime rate is equal to the Federal Funds Target Rate plus 3%. So, if the current fed funds rate is 1.00%, then the prime rate is 4.00%.
The fed funds rate is set by the Federal Reserve and dictates the interest rate at which banks can borrow from other banks. This rate is often referred to as the overnight rate. Banks use the overnight rate as a benchmark to which the prime rate margin is applied. Most banks use WSJ Prime as a benchmark, available from the Wall Street Journal. WSJ Prime is determined by taking the average of the base rate on corporate loans from at least seven of the 10 largest United States banks. The current prime rate is 3.25%.
Federal Funds Target Rate
Why the Prime Rate Matters
Because the prime rate is tied to the fed funds rate, it’s largely immune to market manipulation, allowing banks a benchmark for determining the lowest rates that they’ll offer. Without the Federal Reserve setting the tone for interest rates, currency could become difficult to borrow. Conversely, banks might enter a hypercompetitive market with interest rates, contributing to excess inflationary pressure on interest rates or excessively depressing the financial markets depending on economic conditions.
For most of us, the prime rate matters because it’s tied to so many consumer and business lending products, such as lines of credit, credit cards, and auto loans. When the prime rate is adjusted, the corresponding interest rates on many other lending products move along with it. Paying attention to the prime rate can help make borrowing decisions easier.
Who Qualifies for the Prime Rate
While the prime rate represents the lowest rate a bank is willing to charge its most creditworthy borrowers, this designation is most often reserved in commercial use for large corporations with outstanding credit and liquidity. Some lenders may offer the prime rate as the interest rate on home equity lines of credit for consumers with excellent credit and sufficient equity in their home.
Beyond these scenarios, many 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 Examples
Many financial products use the prime rate as a benchmark rate to which a spread, or margin, is added to make up the loan’s fixed or variable interest rate. To better understand how prime rate influences borrowing, we can look at some examples. For the sake of this example, let’s assume the prime rate is 4.00%.
Sources: St Louis Fed, Fit Small Business
Prime Rate vs Home Mortgage Rate
Many believe residential mortgage rates are linked to the prime rate. In reality, there’s 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’s packaged into mortgage-backed securities (MBS), which are then sold on the bond market. Because MBS are sold on the same market and typically to the same investors as 10-year Treasury Bonds, it’s often thought that 10-year Treasury Bonds and MBS are linked; however, they’re distinct rates and the link is casual.
History of the Prime Rate
Over the past 50 years, there have been two periods where the prime rate has been as low as 3.25%. The first was during the Great Recession in December 2008, lasting until December 2015. The second started in March 2020 due to the COVID-19 pandemic. Prior to this, you’d have to go back to the early 1950s for a prime rate as low as it’s now. The highest prime rate in history was in December 1980 at 21.5%. The prime rate hasn’t been at or above 10% since January 1991:
Alternatives to the Prime Rate
While the prime rate is used by most banks in the US as the benchmark against which rates are set, banks aren’t required to use the prime rate. Some banks, primarily establishments with a large number of international clients, historically used the London Interbank Offered Rate (LIBOR) instead. LIBOR is being phased out in favor of a new benchmark alternative. A primary contender to replace LIBOR is known as the secured overnight financing rate (SOFR). Other contending alternatives include American Interbank Offered Rate (AMERIBOR) and Bloomberg Short-Term Bank Yield Index (BSBY).
While many believe that the prime rate is set at the federal level, it’s instead loosely tied to the Federal Reserve federal funds rate. A common measurement of the prime rate, the WSJ prime, is determined by polling 10 leading US banking institutions. The prime rate determines the cost of borrowing, with a lower rate meaning lower interest rates for businesses and consumers.