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What is the Prime Interest Rate and How is It Set?

written by: Steve McFarlane•edited by: Jason C. Chavis•updated: 12/21/2010

In this article we define prime interest rate (prime lending rate), and explain how it is set and by whom.

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    To define prime interest rates it seems as if our minds willl always be drawn to the sub-prime debacle. Thanks the recent economic meltdown, most of us are quite familiar with what sub prime means, well at least we have a fair idea. Nevertheless, we are well aware that sub-prime mortgages were largely responsible for the collapse of the financial markets.

    It was a time when banks lent money to nearly everyone who wanted a loan and even those who didn’t know they needed one, or didn’t know they could qualify for one. It was a time when banks had forsaken good lending practices in pursuit of bigger profits, and as a result heaped onto themselves sub par debt portfolios. But just what is the prime lending rate that we are often contrasting against? Read on to find a definition of prime interest rate.

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    What is the Prime Interest Rate?

    Prime Interest Rate Definition 

    In essence, prime interest rates are the interest rates that banks charge their best customers. These are usually the best rates that can be obtained from a commercial bank by non-bank customers. These customers qualify for these special rates by having great credit history and the means and liquidity to repay the loan.

    Prime rates are usually gauged on the Feds Funds Rate. These are the rates that banks charge each other for so called overnight loans. Generally speaking the prime rate is 300 basis points above the Feds Funds Rate, but it may vary from bank to bank and is influenced by market forces. Nevertheless, the prime rate usually tracks the movement of the Feds Rate as it moves up and down according to the Central Bank’s monetary policy. For example, if the Feds Funds Rate is 1.5 percent, the prime rate would be somewhere around 4.5 percent.

    Therefore, the trend of prevailing interest rates give some indication as to what the Central Bank is hoping to accomplish in terms of managing economic growth. For instance, by increasing interest rates the government can reduce consumer’s appetite for debt and make it more difficult for business and individuals to qualify for loans, and as a result slow the economy.

    The reverse is also true, by making money cheaper to borrow, the government can stimulate burrowing, and with it economy growth. But as we saw in the recent global economic collapse, making money too cheap for an extended period of time can cause sub-prime customers (customers with a less than perfect credit score) to saddle themselves with debt. Once rates start going up, invariably they would start defaulting on their payments.

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    Conclusion

    The prime-lending rate can be defined as the best rate that non-bank customers can hope to get. However, to define prime interest rate in the minds of many will invariably cause them to reflect on the sub-prime mess. As we saw earlier, commercial banks and the market do have some influence over what level these rates are set at, but in general the prime rate will track the Feds Funds rate.

    Reference:

    William D. Bygrave, Andrew Zacharakis, “The Portable MBA in EntrepreneurshipVolume 35 of The Portable MBA Series. ” John Wiley and Sons, 2009: p 218

    Siegel Joel G., JaeK.Shim “Accounting handbook Barron's Accounting Handbook.” Barron's Educational Series, 2006: P510

    Image Credits:

    “Define Prime Interest Rate” cogdogblog