Prime Rate

What Is the Prime Rate?

The prime rate is the interest rate that commercial banks offer to their most creditworthy borrowers, meaning customers considered least likely to default. Because many other loan rates are priced relative to it, the prime rate works as a baseline for borrowing costs. In the United States, it is commonly cited from a rate published by The Wall Street Journal, based on the rates major banks report charging their best customers.

How the Prime Rate Is Set

Banks generally tie the prime rate to the federal funds rate, the target rate the Federal Reserve sets for overnight lending between banks. The long-standing U.S. convention is to place the prime rate about three percentage points above the upper end of the federal funds target range. When the central bank raises or lowers its target, banks usually move their prime rate by a similar amount, though the timing can vary.

Prime Rate = Upper Bound of Federal Funds Target Range + 3 percentage points

Banks do not have to follow this convention, and each bank sets its own prime rate, so small differences can exist between institutions.

Why It Matters to Investors

Many consumer and business loans have a variable interest rate tied to the prime rate, including some credit cards and home equity line of credits. When the prime rate rises, interest charges on these loans generally rise too, which can increase borrowing costs across the economy. Investors often watch prime rate changes as a signal of how expensive credit is becoming, since higher borrowing costs can weigh on consumer spending, corporate profits, and stock valuations.

The rate a particular borrower pays is usually the prime rate plus a margin reflecting that borrower's credit spread or risk profile. Borrowers with weaker credit typically pay a larger margin above prime, while the most creditworthy customers may pay at or near the prime rate itself.