What is the prime rate?
Prime rate is 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 index can be volatile or remain constant for months on end, depending on the economic climate.
The prime interest rate is what banks charge their most creditworthy customers, because they know those customers are the least likely to default.
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 about 3 percent higher than the federal funds rate. That means that when the Fed raises interest rates, the prime rate also goes up.
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.
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Prime rate example
Robert just got a new credit card. When reading the terms, he learns that his annual percentage rate (APR), or the interest he has to pay on a balance, is 15%, which his bank says is “Prime + 11.25%.” That’s because, this year, the prime rate is 3.75%. Robert’s not one of the bank’s biggest customers; he gets charged the same as the average cardholder.