The prime rate is the interest rate that banks charge to many of their very best customers who want to borrow money. However, the prime rate is often also used to describe the average of the prime rates used by various banks.
Although it can be used to set the interest rate on fixed-rate loans, the prime rate is more commonly seen as the index used in variable (adjustable) rate financing programs, such as credit cards and home equity loans.
The most widely quoted prime rate is the Wall Street Journal Prime Rate and is one of the most common rates used as an index for both commercial and consumer loans. The published rate is calculated based on the Wall Street Journal survey of the largest 30 banks in the country that report their own prime rate to the Journal. The prime rate published by the Wall Street Journal is then seen as an adjusted average or benchmark, followed by other banks.
To avoid any antitrust issues, banks set their internal prime rate independently of other banks. However, they must keep an eye on other banks’ prime rate to ensure a competitive position in the lending market.
Banks may also establish their prime rate based upon the Federal Funds rate set by the Federal Reserve Board. The federal funds rate is the rate that banks may charge one another for overnight lending. The Federal Reserve Board can lower or raise interest rates to increase or decrease the cost of money to stimulate or slow down an economy. To calculate a bank’s prime rate, many banks will typically add around 3.00 percent to the current Federal Funds rate.
The prime rate is one of the most common indexes that lenders use when establishing interest rates for their loans. However, the prime rate is not just for their best customers. It can also be used to assign a rate for any other consumer or commercial loan with variable (adjustable) interest rates. An interest rate for an ARM loan, for example, could be set at “prime plus 3.00 percent” and can adjust up or down as the prime rate moves up or down.
For instance, if the federal funds rate is 0.25 percent, the typical bank’s prime rate would be around 3.25 percent. If the ARM loan is prime plus 3.00, then that means that someone obtaining a loan from that bank would have a final loan rate of about 6.25 percent. The prime rate can also be a tool to calculate an interest rate for a mortgage, a home equity loan and credit cards among other consumer loans.
The prime rate is one of the most closely tracked numbers in the lending market and can be an indicator of the current health of the economy. Even though you may not have a loan that is based upon the Wall Street Journal Prime Rate, you can be sure that lenders who extend credit watch that number every day. When general interest rates rise and fall, it’s often quite likely that the prime rate led the way.
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