Americans who are in the market for a new home, new flashy car or even a shiny new credit card will come across what’s called the prime rate at one point or another. But what is the prime rate, and what effect does it have on the interest rate bank customers have to pay?
The financial market is riddled with jargon that can be difficult to understand for those outside of the industry. However, much of what’s discussed by those who are “in” the banking scene greatly affects how everyday Americans conduct their finances.
One such concept is that of the prime rate. With so much talk over interest rates recently, understanding what this important number means and where it comes from ensures that bank customers are more aligned with banking products they use.
What is the Prime Rate?
Technically, there is no one answer to the question, “What is the prime rate?” However, customers who have demonstrated their ability to maintain good credit are classified as “prime” borrowers. The prime rate, also known as the base rate, is the percentage rate that a commercial institution bestows upon these individuals — its best customers — for loans and other lines of credit.
The interest rate that retail customers receive are highly dependent on their credit score and credit history. Prime customers receive loan and credit rates close to the institution’s prime rate. On the other hand, applicants who have have defaulted on a line of credit in the past or who don’t have a credit history, often find that they qualify for less competitive rates, because banks view these customers are more risky than their prime counterparts.
Depending on which financial institution customers visit, the prime lending rate can vary.
How is the Prime Lending Rate Determined?
Banks establish prime interest rates today, but more often than not, the prime rate closely reflects the federal funds rate. While banks often play the role of lender when issuing loans or lines of credit to their customers, behind the scenes are also borrowers. The federal funds rate is the interest rate that banks charge each other for short-term loans.
Why do banks borrow money from each other? Well, the Federal Reserve requires banks to keep a certain level of of cash reserves at all times, so if a bank finds itself in short supply, they’ll turn to another fellow bank for a temporary loan. The interest banks are permitted to charge on each other’s loans is set by the Federal Reserve Board.
Ultimately, the prime lending rate is the base rate that retail customers see on products such as mortgage and auto loans, and credit card offers in the mail. While banks often promote the prime rate in their marketing materials, the rate that new credit applicants receive can be significantly higher is the applicant is not a “prime” creditworthy candidate.