Differences and Similarities Between Prime Rate and Discount Rate

Q: Who sets the discount rate and how?

The discount rate is approved by the Federal Reserve’s Board of Governors. It is typically raised or lowered to steer the U.S. economy through inflation or a recession.

Q: How do you use the discount rate?

Everyday borrowers don’t have access to the discount rate. Its purpose is to provide commercial banks with overnight loans, not regular consumers. The prime rate (which is based on the federal funds rate) is the rate that most directly impacts everyday borrowers.

Comparing the Prime Rate to the Discount Rate

Lauren WardUpdated June 15, 2022

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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

Figuring out the difference between the prime rate vs the discount rate, which are both used by the federal government, can be confusing. But these two rates are set and used in very different ways. The prime rate is set by the market (based on the federal funds rate) and directly affects the interest rate businesses and people pay for loans. The discount rate, on the other hand, is set by the Fed and is an unpublished rate that banks pay the Fed for overnight loans. It also affects consumer and commercial loan rates, but not directly.Still confused? Not to worry. Here, we take a closer look at the prime rate and discount rate, their similarities and differences, and how they impact the interest rate your small business will ultimately pay for a loan.

What Is the Prime Rate?

The prime rate is the rate lenders give to their most creditworthy customers. These customers are deemed to be at the lowest risk of defaulting on a loan and, therefore, worthy of the best possible rate a bank can give. However, the prime rate is not typically available to most individuals and small businesses, who have a higher likelihood of defaulting than a large corporate entity.However, when you apply for a small business loan, you will likely see lenders mentioning the going prime rate. This is because prime rate influences most financial products, including all types of small business loans.

What the Prime Rate Does

The prime rate effectively establishes the base rate businesses and consumers receive for just about any financial product you can think of, including:

Credit cards
Personal loans
Auto loans
Student loans
Mortgages
Small business loans
Home equity lines of credit

When lenders set the interest rate for their customers, it’s typically prime + X, where X is the margin, or amount of points, that gets added to prime. The margin is based on the creditworthiness of the borrower, which is determined by their credit history, credit score, debt-to-income ratio, and other factors.The prime rate plays a major role in loans that have adjustable interest rates. For example, if your business credit card has a variable annual percentage rate (APR) that changes with the prime rate, your rate will fluctuate along with the prime rate. If the prime rate goes up, variable APRs will typically also go up, and vise versa.Recommended: Are Small Business Loans Fixed Rate or Variable Rate?

How the Prime Rate Is Calculated

The Fed doesn't set the prime rate directly. It is actually set by individual banks based on the federal funds rate, which is the target for the interest rate banks charge each other for short-term loans. The federal funds rate is established by a team of 12 Fed members (called the Federal Open Market Committee) and is based on the economy’s current conditions. Banks generally add 3% to the federal funds target rate when setting the prime rate for their customers.

Is the WSJ Prime Rate the same as Prime Rate?

Yes. The Wall Street Journal, or WSJ, prime rate is the most widely quoted prime rate. The Journal surveys the 30 largest banks, and when three-quarters of them (23) change, the Journal changes its rate, effective on the day the Journal publishes the new rate. Keep in mind, however, that each bank can have its own prime rate. There is nothing in place that mandates banks to be in lockstep with one another. A majority of the time there is a consensus, but that’s because it’s in their best interest to do so. If they charge too much, they’ll lose customers; if they charge too little, they won’t make as much money as their competitors. Recommended: What SOFR Is & How It Works

What Is the Federal Discount Rate?

The Federal Reserve discount rate is the rate the Fed charges banks to borrow money from them. It is not the same as the federal funds rate, which is the rate the Fed suggests banks charge one another. How it works: Banks have two primary ways of borrowing money to meet their short-term operating needs. They can borrow money from other banks and pay the market-driven interbank rate. Or, they can borrow money from the Fed, and pay the federal discount rate. Borrowing from the Fed is a last resort because the Fed-offered discount rates are relatively high compared to the interbank borrowing rates.

What the Federal Discount Rate Does

The Fed uses the discount rate to combat both inflation and recession. When there is too much cash flowing through the economy, the Fed charges banks more interest to discourage them from borrowing. When the economy is lagging, the Fed lowers rates to encourage banks to borrow and stimulate the economy.

How the Federal Discount Rate Is Calculated

Banks receive their rate depending on which lending tier they’re in.

Tier 1 is for banks considered to be exceptionally financially strong. Think of tier 1 as the Fed’s version of prime rate.

Tier 2 is for banks less strong than tier 1, but who are still considered to be in good financial health. Tier 2 borrowers usually pay 50 basis points more than tier 1 borrowers.

Tier 3 is for smaller banks and lenders that have ebbs and flows to their business. Because they are riskier than other banks, they pay the most to borrow from the Federal Reserve.

Comparing Prime Rate vs Discount Rate

The prime rate and the discount rate are two different rates that affect different entities. However, these two interest rates are related and can affect each other.If the Fed decides to charge a higher discount rate to discourage banks from borrowing money, for example, it reduces the amount of money available for consumer and business loans. This typically leads to a higher prime rate. If, on the other hand, the Fed lowers discount rates to encourage banks to borrow, it could increase the amount of money available for consumer and business loans, leading to a lower prime rate. As a rule of thumb, the prime rate adjusts based on how the Fed moves the discount rate.Here’s a closer look at the similarities and differences between the prime rate and the discount rate.

Similarities

Both the prime rate and the federal discount rate represent the cost of borrowing
If the discount rate goes up, the prime rate usually goes up too; if the discount rate goes down, the prime rate usually soon follows suit
Both are influenced by economic conditions
Both can either encourage or discourage borrowers from taking out a loan

Differences

The prime rate is affected by the federal funds rate, which is the rate the Fed suggests banks charge one another for loans
The discount rate is used as a tool to combat inflation or stimulate the economy
The prime rate is the rate that large corporations may receive if their credit history and income are strong enough
The discount rate is the rate that the Fed charges banks for a loan as a lender of last resort

	Prime Rate	Discount Rate
Rate the Fed charges banks:	X	✓
Rate lenders charge their best customers:	✓	X
Used as a benchmark for other loan products:	✓	X
Rate established by the Federal Reserve:	X	✓
Used to combat inflation or a recession:	X	✓
Determined by adding 3% to the federal funds rate:	✓	X

The Takeaway

The prime rate is the rate lenders give their best customers because they pose the least risk of defaulting on payments. The federal discount rate is the rate the Fed charges banks to borrow from them. Its purpose is to combat either inflation or recession by controlling the amount of cash in circulation. The prime rate can be influenced by the discount rate, but it is directly based on the federal funds rate, which is the rate the Fed suggests banks use to loan each other money overnight. All of these interest rates influence the cost of borrowing. However, if you're in the market for a small business loan, the prime rate is the one you need to watch most closely. Typically, you’ll pay the prime plus a margin. The margin will depend on your company’s credit scores, revenues, collateral, and current amount of debt.

3 Small Business Loan Tips

Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find and compare small business loan offers from multiple lenders.
Traditionally, lenders like to see a business that’s at least two years old when considering a small business loan.
SBA loans are guaranteed by the U.S. Small Business Administration and typically offer favorable terms. They can also have more complicated applications and requirements than non-SBA business loans.

Frequently Asked Questions

Why is the prime rate higher than the federal funds rate?

Who sets the discount rate and how?

How do you use the discount rate?

Photo credit: iStock/arthobbit

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About the Author

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.

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