mortgage

Prime rate: what is it and how is it set?

The term prime rate refers to the interest rate that banks charge their preferred customers, or those with the highest credit ratings. It is used to determine borrowing costs on many short-term loan products.

The prime rate is also commonly referred to as the "U.S. prime rate" or the "Wall Street Journal (WSJ) prime rate."

How is the prime rate determined?

The target federal funds rate, which is set by the Federal Reserve Board, serves as the basis for the prime rate. The federal funds rate is the interest rate commercial banks charge each other for overnight lending.

Generally, the prime rate is 300 basis points, or 3 percent, higher than the federal funds rate, although this is not always the case. At any given moment, the prime rate may be slightly higher or lower than 3 percent above the rate set by the Federal Reserve Board.

The prime rate is calculated daily by a number of different sources, most notably The Wall Street Journal. The Wall Street Journal's prime rate index is generally considered to be the "official" source. It establishes the prime rate after determining the daily base rate of corporate loans from 75 percent of the 30 largest banks in the United States.

The prime rate index can be volatile or remain constant for months on end, depending on the economic climate. You can check today's prime rate at Bankrate.com.

How is the prime rate used?

Banks use the prime rate to set interest rates on numerous short-term loan products. These include adjustable-rate mortgages, auto loans, credit cards and home equity loans.

The terms of such loans typically are expressed as prime plus a certain percentage, depending on the borrower's credit rating and other factors. For example, someone considered a good credit risk may qualify for "prime plus 1 percent."

For ways to improve your credit rating and qualify for a rate closest to prime, see Bankrate's feature "5 tips to improve your credit score."

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