Read about prime lending rate, a term that refers to bank interest rates.
The prime rate is typically described as the interest rate at which banks lend money to their best customers, usually corporate businesses that are considered an excellent risk. However, the prime rate should not be confused with the best, or lowest, rate an institution offers. In some situations, a bank may lend money below the prime rate to customers with excellent credit as a means of increasing business.
In most cases, however, banks charge more than the prime rate - the riskier the loan, the higher the interest rate is likely to be. In this sense, the prime rate tends to function as a base for loan products; points get tacked on as a customer's risk factors pile up. Historically, banks simply lent money at the prime rate. Though that is no longer the case, consumers who are looking for a loan or who have adjustable-rate loans should still be aware of how fluctuations in the prime rate affect interest on their debt.
When analysts and bankers refer to the prime rate, they are usually talking about the Wall Street Journal Prime Rate, or WSJ Prime Rate. According to the Wall Street Journal, this number is the base interest rate on corporate loans reported by 70 percent or more of the 10 largest banks in the United States. The prime rate is thus not determined by law, nor is it uniform - it is based on a survey.
Though the Wall Street Journal publishes it daily, the prime rate is not in constant flux. If the rates reported by the nation's biggest banks remain steady, the WSJ Prime Rate will not change. It is considered a handy snapshot of the market, and a vast majority of lenders use it to set their own rates. But how do the nation's largest banks determine their prime lending rate? Their figure is based on the federal funds rate, or fed funds rate, set by the Federal Reserve Bank (also known as the Fed).
According to the Federal Reserve Board, the federal funds rate is the interest rate that banks charge to lend each other money overnight. This figure sets off a chain reaction that determines the rates on everything from corporate loans to credit cards. To reach this target, the Fed has three primary tools: it regulates open market operations, sets reserve requirements and determines discount rates.
As the Federal Reserve Board explains, open market operations are its primary method of implementing monetary policy. By buying up or selling U.S. Treasury Bonds, the Fed can increase or decrease the amount of money available on the market. Reserve requirements have a similar purpose: when the Fed sets a high reserve requirement, it means banks must keep more money in their vaults overnight to cover deposits. The discount rate is the rate at which banking institutions borrow money from the Federal Reserve Bank.
Taken together, these methods can increase the flow of money, thereby lowering interest rates, or make money more scarce, which sends interest rates up. When the economy is headed toward a recession or when credit is scarce, the Fed will implement a monetary policy that keeps interest rates low. When inflation is rising at a fast pace, the Fed may increase the federal funds rate to keep it in check. To determine the federal funds rate, the Federal Open Market Committee (FOMC) meets every six weeks.
When the FOMC meets, it votes on whether or not to change the fed funds target rate. If the committee votes down a change, the WSJ Prime Rate is likely to remain unchanged. If it votes to send the target rate up or down, the WSJ Prime Rate will change quickly. As a general rule of thumb, the prime rate has remained about 3 percentage points above the fed funds rate since the mid-1990s.
Consumers can expect the interest on their variable loans to go up or down depending on the outcome of the most recent FOMC meeting, and consumers shopping for a loan should keep a close eye on market conditions. If the economy is booming, that means the Fed is likely to keep raising interest rates. For instance, according to historic data published by the Federal Reserve Bank of St. Louis, the prime rate reached 9.5 percent in 2000 when economic indicators were strong. Due to market turmoil, the prime rate reached a historic low of 3.25 percent by the end of 2008. If signs point to an economic slowdown, consumers might benefit from holding off on a loan to see if the Fed decides to lower its target rate.