Prime Rate

Prime Rate: Definition and How It Works

Key takeaways
* The prime rate is the benchmark interest rate that commercial banks use when lending to their most creditworthy customers.
* Banks commonly set the prime rate by adding about 3 percentage points to the federal funds rate, though each bank can set its own prime.
* Many consumer and business loan rates (credit cards, HELOCs, variable-rate mortgages, business lines of credit) are priced as prime plus a margin.
* Fixed-rate loans are not affected by changes in the prime rate; variable-rate debt typically is.
* The Wall Street Journal’s daily published rate is the most commonly quoted U.S. prime rate.

What the prime rate is
The prime rate is the interest rate commercial banks charge their best customers—typically large corporations with low default risk. It serves as a reference point: lenders add a margin to the prime rate to set the interest charged to other borrowers based on creditworthiness and other factors.

How the prime rate is determined
* Federal funds rate: The Federal Reserve’s federal funds rate (the overnight rate banks charge each other) is the primary influence on the prime rate. When the Fed raises or lowers the federal funds target, banks often adjust their prime rates in response.
* Common formula: Many banks use a simple rule of thumb: prime ≈ federal funds rate + 3 percentage points. This is not mandatory—each bank can set its own prime.
* Published benchmark: The Wall Street Journal publishes a widely followed daily prime rate, which many institutions use as the market benchmark.

How the prime rate affects loans and borrowers
The prime rate influences interest on many types of variable-rate or adjustable-rate credit:
* Credit cards: Variable-rate cards are often tied to prime; increases raise interest charges on balances subject to variable rates.
* Home equity loans and HELOCs: Interest on these products frequently moves with prime, affecting monthly payments.
* Adjustable-rate mortgages (ARMs): If an ARM is tied to prime, a higher prime increases mortgage payments when rates reset.
* Small business loans and lines of credit: Many commercial lending products use prime as their base rate.
Borrowers with fixed-rate loans are insulated from changes in the prime rate until their loan is refinanced or a new product is taken out.

What a change in the prime rate signals
Changes in the prime rate typically reflect changes in broader monetary policy:
* When the Fed raises the federal funds rate to curb inflation, the prime rate generally rises, making borrowing more expensive and discouraging credit growth.
* When the Fed lowers the federal funds rate to stimulate the economy, the prime rate usually falls, encouraging borrowing and spending.

Who gets the prime rate
Only the most creditworthy borrowers generally receive loans at the prime rate. Other borrowers pay prime plus a margin that reflects credit score, income, collateral, and debt levels. For example, two borrowers might be quoted “prime + 2%” and “prime + 8%” depending on credit profiles.

What loans are not affected
Fixed-rate loans and fixed-rate credit products are not directly affected by prime-rate changes. This includes existing fixed-rate mortgages, fixed-term personal loans, and fixed-rate certificates of deposit.

Brief history and notable high
The prime rate has fluctuated over time with economic cycles. A notable peak occurred in 1980, when the U.S. prime rate reached an all-time high of 21.5% as the Federal Reserve tightened policy to combat inflation. More recently, prime has moved up and down in response to changes in Fed policy and economic conditions.

Bottom line
The prime rate is a foundational interest rate in the banking system that helps determine borrowing costs across a wide range of consumer and business loans. It is influenced by the federal funds rate, set by the Federal Reserve, and serves as the starting point for pricing variable-rate credit. Understanding whether your loans are tied to prime (or are fixed) can help you anticipate how changes in monetary policy will affect your payments.