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What is the Prime Rate? - History & Explanation

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

The Federal Funds Rate gets the attention of the media, but it's the prime rate that really matters to consumers. In this lesson, you'll learn what the prime rate is, how it is established, and why it matters.

Definition of the Prime Rate

The prime rate is the interest rate established by the largest banks in the United States to use as a benchmark for the rates they charge on loans and other debt instruments. The prime rate used to be considered the most competitive rate a bank offered to only its most creditworthy clients. While some banks may still offer loans to clients at their prime rate, there are situations where banks charge a rate less than the prime rate, such as short-term adjustable rate loans.

How the Prime Rate is Calculated

When we talk about the 'prime rate,' we could really be talking about one of two things. The first could be the published prime rate - the rate that shows up on financial websites and in banking publications. This rate isn't taken from a single bank; it's the average of the prime rates offered by the 25 largest banks in the United States.

We could also be talking about a specific prime rate, such as the prime rate for the Bank of America, J.P MorganChase, or Wells Fargo. Individual banks calculate their own prime rate, although for the most part they are consistent and almost always 3% higher than the Fed Funds Rate.

Currently, the Federal Funds Rate is targeted at 0% - .25%, making the prime rate for most banks 3.25%. Indeed, if you were to find a Wall Street Journal or financial website that published the current prime rate, that's what it would say.

How Banks Use the Prime Rate

As mentioned earlier, the prime rate used to be the best rate a bank would give its most creditworthy customers. While this may still be true in some situations, the invention of new types of interest rates and loan terms have made it possible to get a loan with a rate lower than the prime rate. That would still only go to a customer with an excellent credit profile and would involve adjustable rates and pretty significant collateral. But using the prime rate as a benchmark rate is more common than using the prime rate as the actual rate on a loan.

A benchmark rate is a standard rate used to calculate other rates. Many credit cards now offer variable rates that are 'prime rate +.' For example, a good customer with a decent credit profile might have a credit card with the interest rate of 'prime rate + 8.99%.' That means that the interest rate on any purchase is the prime rate at that time, plus 8.99%. Right now, with the prime rate at 3.25%, that would mean the interest rate is 12.24% (8.99% + 3.25%).

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