What is Prime Rate?

Explanation

Suppose you take a home loan from a commercial bankCommercial BankA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits.read more at an interest rate of 7% per annum with a tenure of 15 years. Have you ever thought about what this 7% comprises? Let’s dig into the same –

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Interest Rate to Charged = Prime Rate + Risk Premium + Inflation Premium

Let’s assume the following figures:

  • Prime Rate = 3%Risk Premium = 2% (Risk PremiumRisk PremiumRisk Premium, also known as Default Risk Premium, is the expected rate of return that the investors receive for their high-risk investment. You can calculate it by deducting the Risk-Free Investment Return from the Actual Investment Return. read more is the extra interest charged upon various factors such as the creditworthiness of the customer, income factors, growth factors, the value of a home, etc.)Inflation Premium = 2% (Inflation Premium is charged on the basis inflation situations around the country)

That makes the interest rate charged by the bank to you. So, we were talking about the basic charge, i.e., the prime rate. If you see, most creditworthyCreditworthyCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more customers are not charged with the risk premium. In that case, the interest rate goes with Prime Rate + little margin.

It is decided as follows –

Prime Rate = Feds Target Rate + 3% Usually

The federal funds target rate is the benchmark rate every six weeks. If the Feds Target rate changes, the prime rate also changes. Due to the global chaos caused by COVID-19 – Novel CoronaVirus, the current target rate decided by the Fed is around 0 to 0.25%. Thus, currently, this is trading at 3.25% as of March 15, 2020.

The historical prime rates are as follows:

Determining the Prime Rate

  • Every bank has the right to decide its rate. However, each bank must keep the lending rate near the prime rate.As said earlier, firstly, the committee decides the base rate, i.e., the Federal Funds Target Rate (which currently is 0 to 0.25%). After determining the same, each bank uses it as a base for deciding the prime lending rate.For deciding this rate, banks consider the minimum default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more amongst the customers. Bank would charge lower for lower default high & vice-versa.So, you can now guess that there is no single rate as such & it is usually the average rate charged by the largest banks.

Who Sets It?

  • Firstly, the FOMC (i.e., Federal Open Market Committee) is the authority to decide the base rate, i.e., the Federal fund’s target rate. It meets every six weeks & in such a meeting, it is decided whether to change the base rate. If the base rate changes, the prime rate changes accordingly.The banks then come into play to decide the prime rate to prevail.

Uses

  • Since the base rate is the same, it helps compare the interest rates offered by two banking institutions. Thus, it helps in deciding the business person whether to borrow from Bank A or Bank B.It helps identify the riskier assets of the bank, i.e., those loans where the bank has charged a higher interest rate compared to others.It helps banks determine the rate they can offer to the deposit holders so that they can decide on their profitabilityProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more.It helps to keep inflation under the control of the government.It forms the basis for the other loan products offered by the bank. Thus, this assures the minimum revenue for banks.

Why it’s Important?

  • The interest rate charged by the bank is primarily based on the prime rate & then a little margin over it. So, you can see that all products of any bank, let it be Thus, when the Federal Open Market Committee increases or decreases the base rate, the consequential prime rate will change & thereby, it changes the variable interest ratesVariable Interest RatesVariable interest rate refers to a mortgage or loan interest rate that fluctuates with the market conditions. The interest levied on variable loans depends on the reference or benchmark rate—an index.
  • read more offered on the products. That’s how this rate is important for any financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more.This is the ultimate rate that changes the minimum amount due on your credit card usage, the Equated-Monthly-Installments, the principal component from your EMIs, the interest rate on mortgages, and even on the student loans & whatnot.

This has been a guide to what prime rate & its definition. Here we discuss how the prime rate is determined, along with examples, uses, and why it’s important. You can learn more about from the following articles –

  • What is LIBOR?Negative Interest RateInterest Rate EffectLIBOR Curve