A Guide to LIBOR vs Prime Rate

Q: How is prime rate and interest rate different?

A bank’s prime rate is the rate it charges its most qualified corporate customers, who are highly unlikely to ever default on a loan. An interest rate is the rate a bank will charge other businesses and consumers for loans.

Q: What does LIBOR stand for?

LIBOR stands for the London Interbank Offered Rate.

Q: Why do U.S. banks use LIBOR?

U.S. banks used LIBOR (London Interbank Offered Rate) as a benchmark because of its global popularity and adaptability in setting the rates for future loans. However, due to its role in numerous scandals, LIBOR has since been replaced with SOFR (Secured Overnight Financing Rate) in the U.S.

Comparing and Explaining Prime Rate vs LIBOR

Lauren WardUpdated June 17, 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.

Both the U.S. prime rate and LIBOR are benchmark interest rates that play a role in what banks charge their customers for loans. However, there are some key differences between these two indexes.The prime rate is set by each bank and is tied to the U.S. Federal Funds Rate. While the prime rate is variable, it may remain fixed for long periods of time. LIBOR (London Interbank Offered Rate), on the other hand, is an interest rate average based on what leading banks in London say they would charge for a short-term interbank loan. LIBOR changes daily and reacts to current market events.Another key difference: Prime rate isn’t going anywhere, but LIBOR is now being phased out and will eventually be replaced by SOFR (Secured Overnight Financing Rate) in the U.S. In the meantime, here’s what you need to know about LIBOR vs. prime rate, how these rates are set, and how they affect the cost of borrowing for consumers and small businesses.

What Is LIBOR?

LIBOR has long been a key benchmark for setting the interest rates charged on adjustable rate loans, mortgages, and corporate debt. One reason for its popularity is that LIBOR makes it easy to calculate rates for upcoming dates. You can get a LIBOR rate for an overnight short-term loan, or you can get a rate for 365 days from now.However, due to numerous scandals and questions around its validity as a benchmark rate, the U.S. has largely shifted away from using LIBOR. Therefore, within the U.S. market, it’s no longer a case of LIBOR vs. prime rate, since there are very few scenarios where U.S. banks are allowed to use LIBOR. By July 2023, LIBOR will be replaced by SOFR.

How LIBOR Is Calculated

Every day, the Intercontinental Exchange (ICE) asks roughly 18 global banks at what rate they would charge for a loan in a specific currency and a specific maturity. Those currencies include:

Euro
Japanese yen
Pound sterling
Swiss franc
U.S. Dollar

For each currency, the top 25% and the bottom 25% are removed. The remaining rates are averaged. This is done for each maturity, which includes:

Overnight
One week
One month
Two months
Three months
Six months
One year

In total, there are 35 LIBOR rates published everyday. This is one of the biggest differences between prime rate vs. LIBOR. LIBOR is calculated daily and for multiple currencies, while prime rate is not.

What LIBOR Is Used For

Lenders, including banks and other financial institutions, have used LIBOR as the benchmark reference for determining interest rates for various debt instruments, including mortgages, corporate loans, government bonds, credit cards, and student loans. Apart from debt instruments, LIBOR has also been used for other financial products like derivatives. including interest rate swaps or currency swaps.Though LIBOR will no longer be used for loans in the U.S., it hasn’t fully disappeared yet and will continue to be published until some time in 2023. Some loans may hang on to it as their benchmark until that time.

What Is Prime Rate?

Prime rate is the rate banks give to their best, most creditworthy corporate customers. However, it’s not the rate most businesses will pay. The rate a bank would quote you for most types of business loans will simply be based on the prime rate. The prime rate is also used to set rates for credit cards, mortgages, and personal loans. When comparing business loan rates, you might come across lenders that express the terms of a loan as “prime plus” a certain percentage. The percentage that gets added to prime will depend on the borrower’s credit rating and other factors.

How Prime Rate Is Calculated

The prime rate is tied to the Effective 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 the Federal Reserve and is based on the economy’s current conditions. Banks generally add 3% to whatever the federal funds rate is. Therefore, if the federal funds rate is 2%, then the prime rate would likely be 5%.However, there isn’t any single prime rate. Each bank sets its own prime rate that it charges its best customers. But because banks want to remain competitive with one another, many will actually adopt the same or very similar prime rate. You may have also heard of the WSJ Prime Rate. In a similar fashion to LIBOR, each day the Wall Street Journal asks the largest banks within the U.S. what rate they would charge for a short-term loan to their most qualified customers. When 70% of the banks change, WSJ Prime Rate changes too. Recommended: What Is the Federal Discount Rate?

What Prime Rate Is Used For

Prime rate is used as a benchmark when establishing rates for many loan products. These loan products may include:

Credit cards
Small business loans
Auto loans
Mortgages
Personal loans
Student loans

The prime rate is the starting point for establishing what rate a customer will receive when taking out a loan. However, many things affect what rate a borrower will get. Credit scores, income, debt-to-income ratio, collateral, fixed interest vs. variable interest, and maturity also play key roles in determining how much a person or business will ultimately pay for a loan.

Differences and Similarities Between LIBOR and Prime Rate

There are some similarities between prime rate and LIBOR, as well as some key differences.

Similarities

Both rates are used as reference points for lending transactions.
Both are based on surveys given to large banks asking them at what rate they would lend.
Both tend to move in the same direction as the federal funds rate.

Differences

Prime rate is a reactive rate. It only moves after the federal funds rate has changed.
LIBOR is an anticipatory rate. It moves in anticipation of economic conditions.
LIBOR is used by 5 different currencies, with 7 different maturities.
In the U.S., commercial banks may each have their own “prime rate” that they issue to their most qualified and best borrowers.
LIBOR is published by the ICE.

The most quoted prime rate is published by the Wall Street Journal (WSJ).

	LIBOR	Prime Rate
Created in England	✓	X
Created in the U.S.	X	✓
Offers 35 different rates	✓	X
Used for multiple currencies	✓	X
Each bank has its own rate	X	✓
It is used as a rate index benchmark	✓	✓
Published by the ICE	✓	X
Typically moves in the same direction as federal funds rate	✓	✓
Anticipates economic conditions	✓	X

Pros and Cons of LIBOR

Pros of LIBOR	Cons of LIBOR
Based on what the most prominent banks are lending at	Determined by a relatively small group of banks based on their own judgment
Forward looking – rates can be given out a year in advance	Numerous scandals have put its validity into question

Pros and Cons of Prime Rate

Pros of Prime Rate	Cons of Prime Rate
Rate does not change very often	There is no one single prime rate
Encourages lenders to charge competitive rates	It will not be the rate you will actually pay for a loan

The Takeaway

Both prime rate and LIBOR act as benchmark interest rates. However, LIBOR can be used to calculate future loans because it’s the rate that banks expect they’ll lend at in the coming weeks and months. Prime rate, on the other hand, only represents the going rate. Prime vs. LIBOR was once a talking point among lenders, but since the end of 2021, LIBOR has been steadily phasing out. While still used in some situations, the U.S. has switched to SOFR.As a borrower, a benchmark rate, like prime or LIBOR, is only one of many factors that go into determining the interest rate you’ll pay for a loan. If you’re applying for a small business loan, lenders will also look at your credit scores, time in business, annual revenue, and collateral when determining your rate.

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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

How is prime rate and interest rate different?

What does LIBOR stand for?

Why do U.S. banks use LIBOR?

Photo credit: iStock/GaudiLab

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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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