By BankingMyWay.com Staff
The prime rate, also known as the prime lending rate or prime interest rate, is the rate lenders charge to preferred customers. Preferred customers are the most credit-worthy borrowers such as large corporations. Banks use the prime rate as a basis to set the rates of other loans like mortgages, auto loans and credit cards.

The prime rate can vary slightly from one bank to another, but generally it’s 3%, or 300 basis points, higher than the federal funds rate. The federal funds rate is the interest rate used when banks make overnight loans to other banks at the Federal Reserve. The Federal Reserve Open Market Committee (FROMC) meets eight times a year to establish a target rate for the federal funds rate. The Chairman of the Federal Reserve changes the federal funds rate to balance the supply and demand for funds in the market. In theory, lowering the federal funds rate makes borrowing money cheaper and increases the supply of money in the market. This theory does not always prove true, however, as it is influenced by many other factors.

The Wall Street Journal Prime Rate (WSJ Prime Rate) is the most commonly used prime rate index. This index uses the 30 largest banks in the nation to set its prime rate. When 75% of those banks change their prime rate, the Wall Street Journal changes its prime rate accordingly. Most banks adjust their prime rate when the Fed changes the federal funds rate.

The current economic crisis has caused a severe credit crunch with many lenders afraid to loan money for fear of massive defaults. In an attempt to free up more money in the market and encourage more lending, the Fed has continually cut rates for more than a year. The current target for the federal funds rate is now between 0% and 0.25%. A year ago, the target rate was at 3%

For average consumers, the prime rate is mainly a starting point for other loans. Currently, the prime rate in the U.S. according to the Wall Street Journal is 3.25%, but an average consumer could not get a mortgage with a 3.25% interest rate no matter how well qualified he or she is. Instead, banks add a certain percentage to the prime rate to determine what interest rates to offer. This percentage is determined both by an assessment of the borrower’s risk and profit margin for the bank. The better qualified a loan applicant is, the lower that percentage will be.

The prime rate is the foundation for variable loans like adjustable rate mortgages (ARMs), variable-rate credit cards and some variable-rate home equity lines of credit. Rates on these loans are often specified in terms of prime rate plus a margin. For example, a credit card may have a variable interest rate of “prime plus 7.5%.” At the moment, interest would be charged on that credit card at a rate of 10.75% (3.25% + 7.5%).  The low-rate environment is beneficial to those with variable-rate loans.

On the other hand, the low-rate environment also makes it hard to earn interest on savings. Interest rates on bank products like certificates of deposit (CDs), money market accounts and savings accounts have all dropped as well. While consumers may be paying less in finance charges, they are also earning less in interest income.

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