What is Prime Rate?
The prime rate is one of the main factors banks use to determine interest rates on loans. As noted by Forbes, if you’re in the market for a new variable rate mortgage or a personal loan, understanding the prime rate and how it works can give a consumer a better grasp on how much they will pay and the best time to get a loan.
Prime Rate Definition
The prime rate is the interest rate banks charge their best customers for loans.
But the prime rate is only one factor among several that determine how much you’ll pay for loans, a Forbes feature on prime rates noted. Banks also take into account creditworthiness—the more likely one is to pay them back, the lower the rate they would charge and vice versa.
Who Gets the Prime Rate?
Banks usually only charge the prime rate to large, corporate customers with lots of financial resources. That’s because they have more money and assets to pay the loans back.
Since individual consumers do not have the same resources, banks typically charge them the prime rate plus a surcharge based on the product type they want. On the other end of the spectrum, a bank’s very best borrowers may be able to negotiate lower than the prime interest rate. This kind of negotiation happened more frequently in the 1980s, Garretty notes, when interest rates were much higher. Lenders would try to attract “blue chip” borrowers by offering interest rates lower than the prime rates.
How Does the Federal Funds Rate Impact the Prime Rate?
The federal funds rate is an interest range set by the Federal Reserve. The fed funds rate is the Fed’s recommendation for what banks should charge when they lend money to each other overnight to meet reserve requirements.
The prime rate moves only when the federal funds rate moves. Once a bank changes its prime rate based on the new federal funds rate, it will then start adjusting rates for many of its other lending products in the same direction. And when the federal funds rate and prime rate go down, other rates fall too, making it less expensive to borrow.
Note that certain lending products, like fixed rate mortgages and some student loans, are based on measures like SOFR and are less tied to the movement of the prime rate.