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Prime Rate Defined and Explained

Prime Rate Defined and Explained
Lauren Ward
Lauren WardUpdated May 6, 2022
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The prime rate is a key interest rate that influences most other lending rates. While very few borrowers actually receive the prime rate, knowing what the going prime rate is can give you a sense of the type of interest rate you can expect to pay when borrowing money, whether it’s for yourself or your business. Read on to learn how the prime rate is determined, how it moves, and how it affects the cost of business and consumer loans.

What is Prime Rate?

The prime rate (also known as the prime lending rate or simply the prime) is the interest rate that commercial banks charge their most creditworthy corporate customers – entities that are highly unlikely to ever default on a loan. LIke any interest rate, it provides a way to cover costs associated with lending and compensates banks for the risks they take when extending credit to clients. While you would never pay the prime rate on a loan, the rate you’re quoted will be based on this rate. Prime forms the basis of, or starting point, for most other interest rates — including rates for mortgages, different types of small business loans, credit cards, and personal loans — even if prime is not specifically cited as a component of the rate. In some cases, however, a lender will express the terms of a loan as prime plus a certain percentage, which will depend on the borrower’s credit rating and other factors.

How Does Prime Rate Work?

For most borrowers, the prime rate is not the same as their interest rate. As the name "prime" implies, it tends to be the best — a.k.a lowest — interest rate the financial institution charges.Lending and borrowing money largely looks like a pyramid, and has three tiers: 
  • Banks to banks
  • Banks to large corporations
  • Banks to standard borrowers
The closer you are to the top, generally the less you’ll pay to borrow. If you’re a regular customer with a bank (meaning you are not borrowing on behalf of a large corporation with billions of dollars in assets), then you will pay prime plus a certain percentage.Although prime is a variable, or floating, interest rate, it can remain stable for years. During economically turbulent times, however, prime might change several times in one year.

A History of Prime Rate

The prime rate has risen and fallen over the years. On December 1, 1947, it started as 1.75%, but over time it gradually grew. The prime reached its highest to date on December 19, 1980, where it hit 21.50%. Since then, it has bounced back and forth between 3% and 8%. Recommended: LIBOR vs SOFR and the Transition to SOFR, Explained 

How Prime Rate is Calculated

The prime interest rate is largely determined by the federal funds rate, which is the rate banks charge each other for overnight loans. The banks then take that rate (which is set by the government) as the starting point in setting the prime rate for their best-qualified clients.Each bank sets its own interest rate, so there is no single prime rate. Any quoted prime rate is usually an average of the largest banks' prime rates. The most important and most used prime rate is the one that the Wall Street Journal publishes daily, which is based on surveys of  70% of the largest U.S. banks. 

Prime Rate vs Federal Funds Rate

While the prime rate isn’t set by the government, it is based on the federal funds rate, which is set by the Federal Reserve (a.k.a the Fed). The Fed sets and adjusts the federal funds rate to keep the U.S. economy on an even keel. When the economy slows, they lower the rate to stimulate economic growth. When the economy expands too quickly, they lower the rate to try to head off inflation.The prime rate runs about 3% higher than the federal funds rate. That means that when the Fed raises interest rates, the prime rate also goes up, and vice versa. As of April 2022, the federal funds rate is 0.33%, while the prime rate is averaging 3.5%.Here’s a closer look at the prime rate vs. the federal funds rate:Recommended: What Is the Federal Discount Rate? 

Prime Rate Example

When you’re applying for a small business loan, you may see a lender advertise its rate as starting at prime + 4%. If the prime is currently 3.5%, this means the lowest rate you can receive from this lender is 7.5%. Your business’s credit score and financial history will determine just how close to that amount you get when you apply. 

How Prime Rate Affects You

The prime rate is the best possible interest rate you can get as a borrower when working with a commercial bank, but only the largest, most stable corporations qualify for the prime rate. There is a domino effect, however. Personal loans, small business loans, credit cards, and mortgages all carry interest rates that are based on or tied to the prime rate. If you take out a fixed-rate loan, it'll be based on what the prime currently is. If you get a variable-rate loan, the rate will fluctuate along with the prime. If you are thinking about getting any of the following loan products, here’s what you need to know.

Mortgages

When you buy a house, there are a variety of factors that influence what type of interest rate you get. Your personal financial history, down payment, loan amount, and length of the mortgage are all important factors. The starting point, however, is the prime rate. If you have an adjustable-rate mortgage, it will fluctuate as the prime fluctuates. If you have a 30-year fixed mortgage, it can sometimes make sense to refinance if the prime rate goes down.

Business Loans

Rates for loans backed by the U.S. Small Business Association (SBA), as well as other small business loans, are based on the prime rate. An SBA 7(a) variable rate loan, for example, runs 2.25% to 4.75% above the prime rate. The exact business loan rate you will get quoted will depend on the amount of the loan and your business’s financial and credit history.

Consumer Loans

A consumer loan is a loan given to consumers to finance specific types of expenditures. Types of consumer loans include:
  • Mortgages
  • Personal loans
  • Credit cards
  • Auto loans
  • Education loans
  • Refinance loans
Whether the rate is fixed or variable, consumer loans also closely track the prime rate. Even though credit card rates are usually much higher than the prime rate, for example, they are still affected by it. Most credit cards have variable interest rates set a certain number of  percentage points above the prime, such as prime + 13.99%. As the prime rate changes, you will see the increase or the decrease in your card's annual percentage yield within a billing cycle or two. 

The Takeaway

The prime rate is the interest rate that commercial banks charge their most creditworthy corporate customers. Although it is not an official interest rate — or even one single interest rate — the prime rate acts as a starting point for most consumer and business banking products. If you're in the market for a small business loan, for example, the rate you will be quoted will depend on the current prime rate, as well as the type of loan, your qualifications as borrower, and the lender. If you’re interested in viewing current business loan rates, Lantern by SoFi can help. With just one short application, you can instantly access multiple small business loan offers matched to your company’s needs and qualifications.
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Frequently Asked Questions

What is the difference between prime rate and interest rate?
What is the lowest the prime rate has ever been?
How high can the prime rate go?

About the Author

Lauren Ward

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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