The prime rate is the interest rate banks or lenders charge their most preferred and credit-worthy customers. Often, loan products like personal and automobile loans use the prime rate as a base rate. Credit cards and certain types of commercial financing may use the prime rate as a base as well. Typically, personal loan and credit card customers are charged interest rates that are at least a few points higher than the prime rate.
As the prime rate is tied to credit, interest rates increase as creditworthiness declines. The rate also fluctuates depending on economic conditions. Furthermore, the prime rate may vary among different banks.
Each bank or financial institution quotes its own prime rate. Often, financial institutions choose to offer prime rates that have been set by large commercial banking institutions. In the United States, some financial institutions may look to the Wall Street Journal for the average prime rate of the more prominent commercial banking institutions.
When banks give rates to their credit card customers, they often start with the prime rate and add a percentage. This percentage varies and reflects the bank’s perceived risk in offering the credit card account. The percentage added to the prime rate also includes a profit for the bank.
The prime rate is generally about three percent higher than the federal funds rate. The federal funds rate is the rate that banks charge when lending to each other. In turn, the federal funds rate is determined by the rate at which banking institutions borrow from the Federal Reserve. That rate is called the discount rate.
Those most likely to benefit from borrowing at the prime rate are large corporations. This is because banking institutions tend to believe that their large corporate clients are less likely to default on loans than other types of customers. When customers pose little risk to banking institutions, those institutions feel more comfortable lending to them and offering more attractive rates.
Sometimes, the term subprime is used in relation to loans and other financial products. Subprime financial products can consist of loans, credit cards, and lines of credit intended for those with low credit scores or individuals with scant credit histories. Individuals with blemished credit histories are not able to take advantage of the prime rate. These individuals are usually charged a higher or subprime rate because of the perceived risk to the lenders.