Definition
The term prime interest rate historically referred to the rate of interest charged by banks for loans made to their most creditworthy customers. Today, the prime interest rate is used as a benchmark, against which rates are set for mortgages, as well as small business loans, personal and student loans.
Calculation
Prime Interest Rate = Federal Funds Rate + 300 Basis Points
Where:
One basis point is equal to 0.01% (100 basis points = 1.00%)
The Federal Funds Rate is set by the Federal Open Market Committee (FOMC), which meets every six weeks. During these meetings, the committee votes on any change to the target rate for Federal Funds.
Explanation
Also known as the prime lending rate, the prime interest rate was the rate of interest charged by large financial institutions to their most creditworthy customers. The rate of interest charged on a loan is a function of both the bank's cost to borrow as well as the risk of default on a loan. Since their most creditworthy customers present a very small risk of default, they were able to secure loans at the "prime" rate.
Today, the prime interest rate acts more like a benchmark, or index, against which a variety of loans are made to borrowers. Student loans, mortgages, small business loans, and personal loans oftentimes reference the prime lending rate or use it as an index. The Wall Street Journal publishes the prime lending rate each week, and this is considered the definitive source of this information. The London Interbank Offered Rate, or LIBOR, is now oftentimes used as a benchmark, replacing the prime lending rate in this role too.
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