Understanding Prime Rate

What Is the Prime Rate?

The prime rate, or prime lending rate, by definition is the lowest interest rate lenders are willing to offer. Lenders utilize the prime rate as a foundation for pricing their short-term and medium-term loan products.

Note that lenders are only willing to offer the prime rate to their absolute most trustworthy clients on a verifiable basis that there is very little risk of default. For less creditworthy borrowers, lenders will typically use their prime rate as a base interest rate and then add a margin based mostly on the amount of risk associated with the deal in order to make a profit — the more risk involved, the higher the margin.

The prime rate is a widely utilized concept because banks and lenders all want to offer potential investors loan products at both profitable and competitive rates. After all, the prime rate is not a law, but a benchmark — a standard, even — that is recognized across the entire industry. While it is true that each bank sets its own prime rate, these individual rates are consistently tied to the U.S. benchmark rate of choice — the federal funds target rate, or FFTR. Oftentimes, a lender’s prime rate will rise or fall in tandem with the FFTR.

The U.S. Prime Lending Rate

The U.S. prime rate as a standard makes the job of comparing loan products from different lenders an easier and substantially more efficient task for investors. The U.S. prime rate is extremely helpful because it remains constant no matter where in the country you are. There is, however, often confusion surrounding how the U.S. prime rate is determined.

The typical U.S. prime rate that an investor may come across is usually the result of one of two determination methods. It is either an average of all the prime rates of America's top banks and lenders, or the FFTR plus 300 basis points, or 3%. Since the standard benchmark most banks use to determine their unique prime rates is the FFTR, the two different methods of determining the U.S. prime rarely yield very different results. Additionally, since around the second quarter of 1994, the industry’s rule of thumb regarding the U.S. prime rate was to add 300 basis points to the federal funds target rate. As an example, if the federal funds rate is 0.30%, then the U.S. prime lending rate would be 3.30%.