What is the Prime Rate

At one time the prime rate was the rate that lenders charged their most credit worthy borrowers. This is no longer strictly the case in the American banking system. Now banks use the prime rate as a marker, a standard by which to adjust and determine rates.

The prime rate is typically the same at most banks, although it can vary from bank to bank it seldom does and banks usually adjust prime at the same time.

The prime rate is used in calculating some variable rate loans. This often includes secured loans like home equity loans and lines. Most credit card rates are also based off of the prime rate.

So how is this rate determined?

The prime rate has recently been tied to the Federal Funds Rate; usually prime rests at three points over this rate. The Federal Funds Rate is the interest rate that banks get charged for overnight loans. Banks take these loans to meet reserve requirements.

On February 23, 2008 the Federal Funds Rate is 3.00% and prime is 6.00%. The Federal Open Market Committee (often referred to simply as “the Fed”) meets eight times a year when they set the Federal Funds Rate.

Recently the Fed met for an emergency meeting one week prior to their scheduled meeting last month. This emergency meeting represented an extra meeting, the regularly scheduled meeting occurred the following week. At both meetings the Federal Funds Rate was cut.

Lately the Fed has been dropping rates, but under normal economic conditions the Federal Funds Rate stays pretty consistent.

The prime rate is not fixed at 3.00% over the Federal Funds Rate however, and can change apart from the Fed meeting. Prime is actually established by the banks themselves.

The most common prime rate index is the Wall Street Journal Prime Rate (WSJ Prime Rate). This prime rate is determined by measuring the base rate on loans by a minimum of three quarters of the country’s largest banks.

This means that prime, by definition, does not change often, only when banks need to alter lending rates. Banks generally maintain this rate at the Federal Funds Rate plus three percent.

Until December 16, 2008, when at least 23 of the nations largest 30 banks adjust their prime rate (always in response to rate moves by the Fed in recent times) the WSJ Prime rate is also adjusted.

The prime rate is used to determine interest rates for many variable loans. It historically has been tied to the Federal Funds Rate but it does not have to be. As banks adjust their lending rates the prime rate will also adjust.