What is Prime Rate and how is it calculated
What is Prime Rate and how is it calculated

What is Prime Rate and how is it calculated?

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Prime Rate and how is it calculated: A preferential interest rate (or prime rate, in English) is a rate charged by banks to their most solvent corporate clients. The federal funds rate of a certain day serves as the basis for the prime rate. The prime rate in turn serves as the basis for most other interest rates.

Imagine that you want to borrow money for a home improvement project. When you look at the terms of different types of loans, including home equity loans and 401(k) loans, you note that some of them list their interest rate as a percentage “above prime.”

If you don’t know what “preferred” means or how much it is, how are you supposed to compare these loans?

The term “prime” refers to the prime rate of interest, also called the prime rate or prime rate. This is the lowest rate at which a commercial bank will lend money to someone other than another bank.

These rates apply only to the most creditworthy customers, corporations and individuals with exceptionally high credit scores. Those who don’t pay the prime rate have to pay a percentage, just like when you borrow money from a bank.

Understanding the prime rate

Commercial banks charge their most solvent customers, generally large companies, the prime rate. The prime lending rate is mostly determined by the federal funds rate, which is the overnight rate used by banks to lend to one another.

Most other interest rates, including mortgage rates, small business loans, or personal loans, are based on the prime rate. Although the prime rate is not specifically mentioned as part of the fee, it is nevertheless a significant component.

Interest rates serve to cover the costs associated with loans as well as compensate the lender for the risk he assumes based on the borrower’s credit history and other financial details.

Almost all other interest rates are determined by the prime rate plus a percentage.

Prime Rate Definition

The prime rate is the interest rate set by the largest banks in the United States to use as a benchmark for lending and other debt instruments. Banks used to offer prime rates only to their most creditworthy customers as the most competitive rate. Despite the fact that some banks still offer loans to customers at prime rates, there are situations where banks charge a rate less than the prime rate, such as short-term adjustable-rate loans.

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How the prime rate is set

Technically, there is no official national prime rate. Instead, each lender sets its own. The majority of banks set their prime rates at the same level and adjust them at the same time.

Frequently, when people talk about “the” prime rate, they are referring to the WSJ Prime Rate, a benchmark based on a survey of the ten largest US banks calculated by The Wall Street Journal. At least 70% of these banks must adjust their prime rates to affect the WSJ’s prime rate.

The Prime Rate and the Fed

It is a common belief that the Federal Reserve sets the prime rate, but that is not strictly true. Fed sets the federal funds rate, the rate at which financial institutions lend money to each other.

Most banks, however, base their prime rates on the fed funds rate, raising and lowering them in sync with changes in that rate. Therefore, the prime rate is typically about 3% higher than the Fed funds rate.

The prime rate and Libor

The prime rate is only used by US banks. International banks traditionally use a benchmark rate called the London Interbank Offered Rate (Libor). For more than 40 years, international banks have relied on Libor to set their rates for loans to each other and to their customers.

The US Federal Funds Rate and Libor do not have an official connection. However, the two have tended to rise and fall together, with three-month Libor hovering around a few tenths of 1% above the fed funds rate.

Libor used to be between 2.5% and 3% below the US prime rate. When Libor and the Fed funds rate diverged, it was usually a sign of some kind of problem in the financial markets.

However, as Forbes reported in December 2020, international banks are moving away from Libor as a benchmark.

Libor has played an important role in the financial crisis of 2007-2008, where the Fed kept lowering the Fed funds rate, but Libor rose as international banks tried to make it more difficult for US banks to borrow.

Researchers discovered in 2012 that several banks, including Barclays, UBS, and Deutsche Bank, manipulate Libor rates for profit. Due to recent scandals and changes in the way banks conduct their business, Libor has also become less reliable as a benchmark.

Libor is calculated by the Intercontinental Exchange (ICE) Benchmark Administration, which may stop doing so in 2021 because of these issues. US banks that currently use Libor for international loans are likely to replace it with the Interest Rate. Secured overnight financing (SOFR), a measure of how much investors charge banks for loans backed by U.S. Treasury bonds.

We don’t yet know what replacements international banks will use for Libor and how closely they will follow the fed funds rate and the prime rate.

How the prime rate is calculated?

When we talk about ‘prime rate,’ one of two things can be meant. One of the first would be the published prime rate, which appears on financial websites and banking publications. It is not a single bank’s rate; it is the sum of the prime rates offered by the 25 largest banks in the United States.

There is also the possibility that we are discussing a specific prime rate, such as the Bank of America, JP Morgan Chase, or Wells Fargo Prime Rate. For the most part, banks calculate their own prime rates, although they are almost always 3% higher than the fed funds rate.

As of this writing, the fed funds rate is targeting 0% – 0.25%, making the prime rate for most banks 3.25%. Similarly, if you found a Wall Street Journal or financial website that published the current prime rate, that would be what it would say.

Credit cards are not the only loans that refer to the prime rate. The prime rate is often used as a benchmark in adjustable rate mortgages as well. In fact, the interest rate on a loan is usually ‘prime rate +’, although the amount added to the prime rate is usually substantially less with a mortgage because there is collateral.

Determine the prime rate or preferential interest rate

An interest rate charged by a bank is primarily determined by the risk of default. Since a bank’s best customers are unlikely to default on a loan, it may charge them a lower interest rate than it charges a customer who is more likely to default.

The prime rate is not set by a single bank, but rather by each individual. A prime rate is usually an average of the prime rates of the largest banks. The Wall Street Journal publishes a prime rate each day that is the most important and widely used. Federal Reserve (the Fed) changes its prime rate regularly, and other financial services institutions in the United States may use them to justify changes in their own prime rates, but they are not required to match the changes.

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Relationship to Variable Interest Rates

Variable interest rates, such as those on some credit cards, may be expressed as prime plus a fixed percentage. Therefore, the interest rate goes up and down based on the prime, but will always remain a fixed percentage higher than the prime rate.

Prime rate and the most qualified customers

Primarily, preferential interest rates are reserved for the most qualified clients, those who pose the least default risk. A prime rate may not be available to individuals as often as they are to larger entities, such as corporations and particularly stable businesses.

A lender may offer rates below 5% to well-qualified borrowers even if the prime rate is set at a certain percentage, say 5%. The Prime Rate is used only as a reference and should not be considered a mandatory minimum despite it likely being the lowest advertised rate.

Changes in the prime rate

The Federal Open Market Committee (FOMC) sets the federal funds rate. Approximately every six weeks, the FOMC meets to discuss whether this interest rate should be changed.

The FOMC is likely to lower the Fed funds rate when the economy is weak. Consequently, the prime rate is reduced, making it easier for borrowers.

By putting more money in the pockets of consumers and businesses, both of which can stimulate the economy, consumers can spend more and businesses can invest more.

The FOMC tends to raise the Fed funds rate when the economy is booming and runaway inflation appears to be a threat. As a result, the prime rate goes up, which discourages borrowing, leading to people and businesses cutting back on spending. Low consumer spending encourages merchants to keep their prices low, which helps control inflation.

According to a graph from JPMorgan Chase, the prime rate has changed over the past 35 years. Over the boom years of the 1980s, the prime rate rose as high as 13% as the FOMC tried to rein in inflation.

In contrast, during the recession that began in 2008, the prime rate dropped to 3.25% and stayed there for years as the FOMC tried to spur the economy.

The FOMC responded to the recession caused by COVID-19 by once again lowering the fed funds rate to near zero in March 2020. In response, the prime rate also fell back to its historical low. As of December 2020, the prime rate stands at just 3.25%.

Why the prime rate is important?

Prime rate changes can affect your life in two different ways. In the first place, they affect your interest rate on any type of debt, from a student loan to a credit card.

Second, they can cause changes in the economy as a whole. As a result, the prime rate indirectly influences everything from the prices you pay in stores to your chances of landing a job.

How the Prime Rate Affects Borrowers

All types of loans experience an increase in interest rates whenever the prime rate rises.

An increase in the prime rate could reduce the interest rate on any loans with variable interest rates, such as credit cards, adjustable-rate mortgages (ARMs), or home equity lines of credit (HELOCs). The interest rate on these loans would increase immediately. As a result, you could face higher monthly payments on your ARM or higher minimum payments on your credit card debt.

You won’t be affected by changes in the prime rate if you have a fixed-rate mortgage or any other fixed-rate loan. A change in the prime rate will not affect the annual percentage rate you are offered if you are looking for a new loan. This could be a car loan or personal loan.

Mortgage rates for 30-year loans don’t change automatically when the prime rate rises or falls, but if the prime rate moves up or down and stays there, chances are the mortgage rate will eventually follow.

It is for this reason that the news media pay such close attention to FOMC meetings and any statements made by the chairman of the Federal Reserve. The Fed’s talk about raising or lowering interest rates can affect people’s decisions about borrowing money.

When you’re considering buying a car, refinancing your mortgage, or refinancing your auto loan, and you hear that interest rates are likely to rise soon, it may be a good idea to apply for your loan now, while rates are still low.

Alternatively, if news reports suggest that interest rates could fall, you can wait and see if you can get a better interest rate in a few weeks or months.

How the Prime Rate Affects the Economy

The prime rate changes are obviously important to borrowers, but their effects don’t end there.

As a result, all people and businesses doing business with borrowers are affected by the impacts on borrowers. Eventually, this could lead to major changes in the economy as a whole.

As an example, let’s say you own a house with an ARM. Getting a lower principal interest rate will lower your monthly mortgage payment and free up cash in your budget.

You may respond by spending more on luxuries you’ve shied away from in the past, like restaurant meals, entertainment, or vacations. Restaurants, movie theatres, airlines, and hotels, in turn, benefit from your increased spending in these areas.

You don’t make much of a difference to these businesses based on your individual behaviour. However, if every ARM holder in the country reacts the same way you do to having more money in your pocket, the additional purchases will add up over time.

Profits will increase, and these companies will be more likely to hire more employees or open new branches. A more prosperous economy will result, as it will create new jobs.

Additionally, lower interest rates directly affect businesses. The banks make it easy for them to borrow money so that they can hire more workers, build new facilities, or invest in new equipment. Low interest rates lead to business expansion and faster economic growth.

As a result, a newspaper report that the Fed is planning to reduce rates is a sign that the economy will soon improve. This growth could, however, lead to higher inflation, so you may want to take some steps to safeguard yourself from rising prices.

Conversely, if interest rates are about to go up, the economy may slow down a bit, and it might be time to prepare for the next recession.

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Key Information

  • Commercial banks charge their most solvent corporate clients what is known as the prime rate, or preferential interest rate.
  • Prime rates are used to calculate mortgage rates, small business loans, and personal loans.
  • Prime rates are published daily by the Wall Street Journal, which is the most important and most widely used.
  • Prime Rate: The interest rate set by the largest banks in the United States as a benchmark for the interest rates they charge on loans and other debt instruments.
  • Published Prime Rate: The rate that appears on financial websites and in banking publications
  • Specific Prime Rate: The prime rate set by a particular bank or lending institution.
  • Reference Rate: The standard rate used in calculating other rates.

Last conclusions

There’s nothing you can do about changes in the prime rate, but you can take steps to minimize the impact on you. When you hear that interest rates are going up soon, you can protect yourself by paying off credit card debt and other adjustable-rate loans before they become more expensive.

If you have an adjustable-rate loan you are unable to pay off as quickly, like an ARM, you can avoid rising costs by refinancing to a fixed-rate loan. In addition, if you anticipate needing a new loan soon, get it now while interest rates are low.

Another way to prepare for an increase in the prime rate is to start saving more money. Higher interest rates are bad news for borrowers, but great news for savers because they earn more interest on their savings.

Don’t lock yourself into any long-term certificates of deposit (CDs) just yet. You can get a better return by waiting for interest rates to rise.

Alternatively, if interest rates are expected to drop, it would be wise to wait a while before applying for a new loan. Wait until the prime rate drops before applying for a new loan to get a better rate. In the meantime, work on improving your credit score.

When you apply for a new loan, you will be able to qualify for the prime rate instead of paying an extra percentage point.

Learning outcomes

With this lesson, prepare for these steps:

  • Define prime rate
  • Calculate Prime Rate
  • Summarize how banks use the prime rate