Prime Rate

What is a Prime Rate?

The term “prime rate” refers to the interest rate commercial banks tend to charge their corporate customers with a healthy credit profile. In other words, the commercial banks charge lower interest rates to preferred borrowers as they are less likely to default, which means the loans are safer. It is decided based on the federal funds rate in the US, which the Federal Reserve Bank fixes. Typically, the prime rate is fixed around 300 basis points above the federal funds rate. The prime rate is known as the prime lending rate or PLR.

Examples of Prime Rate

Let us look at a simple example to understand how this is used in the banking industry. Suppose David has applied for a home loan from a commercial bank, XYZ. The loan has been sanctioned at an interest rate of 8% per annum with a tenor of 20 years. Now, let us dig deeper to understand how the interest rate is derived from the prime rate of 3% per annum.

Typically, the interest rate to be charged is derived based on three main components – prime rate, risk premium, and inflation premium.

The risk premium is charged based on multiple factors, such as the customer’s creditworthiness, the home’s value, etc. On the other hand, the inflation premium considers general price increases in the country.

Let us assume that the risk premium is 2% and the inflation premium is 3%. In this way, prime rate (3%), risk premium (2%), and inflation premium (3%) have been used to derive the interest rate (8%).

If the case of a very creditworthy customer, the bank may not charge the risk premium or even the inflation premium. So, the interest rate will be solely based on the prime rates.

Breaking down Prime Rate

Commercial banks typically charge a lower rate that works best with their preferred set of customers. It means that many different prime rates are floating around in an economy. Hence, the single prime rate figures are usually calculated as the average of all the available prime rates that some major commercial banks charge.

Although these rates are mostly associated with large corporations, they can also be of some interest to other individuals within the business ecosystem as they can influence the interest rates of other financial products, such as personal loans, credit cards, mortgages, or loans for SMEs.

If the prime customers of any commercial bank witness deterioration in their credit decrease, it is usually seen as an early warning of an imminent downward pressure due to the economic climate that can adversely impact all other bank borrowers. Thus, the interest rates for all other financial instruments like mortgages or personal loans are likely to react to the increase in the prime rates.

Uses of Prime Rates

There are several uses, and some of the most significant ones are as follows:

• All banks use the same prime rates as their base rate. So, a borrower can compare the interest rates offered by two banking institutions.
• It helps identify the riskier loans, i.e., loans with higher spreads over the prime rates were the riskier assets of the bank.
• It helps in keeping inflation under the government’s control.
• In most cases, it is the minimum interest rate charged by the banks. So, it helps in determining the minimum revenue for banks.

Prime Rate Graph

It is closely linked to the overnight or federal rates, the interest rates banks charge while lending money to other banks. If the federal rate increases, the commercial banks’ creditworthiness declines, as witnessed around 2006-2007 (in the graph below). So, it can indicate that the overall economy is struggling. In short, when large corporations face trouble or run into difficult economic conditions, the prime rates invariably increase.

The graph for prime rate sourced from FRED shows two major spikes between 2000 and 2021. The first peak of 9.50% between August 2000 to December 2000 came just after the dot-com bubble shocked the entire world. Again, the next spike of 8.25% between August 2006 and August 2007 came around the financial crisis of 2006-07.

Source: FRED

Key Takeaways

Some of the key takeaways of the article are:

• It refers to the interest rate the commercial bank charges their most creditworthy corporate clients.
• The interest rates offered for other financial products, such as personal loans, business loans, and mortgages, are determined based on it.
• The interest rate charged to borrowers other than the prime customers is derived based on three main components, i.e., Interest rate = Prime Rate + Risk Premium + Inflation Premium.
• If the prime rates of commercial banks go up, it can be seen as an early warning of imminent downward pressure on the overall economy.

Conclusion

So, it is usually set aside only for the most creditworthy customers with the least amount of default risk. It means that prime rates are not available to borrowers other than large and stable businesses. However, it is used as the benchmark for various other financial products. Hence, although other borrowers don’t enjoy its benefits, their financial borrowings are influenced.

Recommended Articles

This is a guide to Prime Rate. Here we also discuss the definition, examples, uses, and graph of Prime Rates along with its breaking down. You may also have a look at the following articles to learn more –

1. Prime Cost
2. Subprime Loans
3. Hedge Fund strategies
4. Prime Cost Formula