Prime rate or prime lending rate is a term which is used in many countries for referring interest rate charged by banks to each other. The term earlier signified the rate of interest at which banks lent to privileged customers, i.e., those with strong credibility in the market; however, this is no longer the case. Some variable interest rates may be applied as a percentage over or under prime rate.
Prime Rate In banking System
In the past, the prime rate used to be an actual interest rate in North American banking; although this is no longer the case. The prime rate is almost same among banks, and adjustments are normally carried out by banks at the same time, nevertheless, changes does not occur with frequency.
In the U.S., the prime rate stands roughly 300 basis points (or 3 percentage points) above the federal funds rate. Thus, the interest rate that banks charge to each other for overnight loans made to satisfy reserve funding requirements is: (federal funds rate/ base rate/benchmark rate) + (3 %) = (prime rate).
The Federal funds rate plus a very small additional interest rate is normally charged by banks for lending to the most creditworthy borrowers today. In the U.K. this is called as LIBOR, the London Interbank Offered Rate. The Federal Open Market Committee (FOMC) convenes for eight times in a fiscal year wherein the policy makers fix a target for the federal funds rate. Other rates, including the prime rate, are decided using this base rate.
Before December 17, 2008, when 23 out of 30 of the United States’ largest banks altered their prime lending rate, the Wall Street Journal used to change its published rate. On December 17, 2008, the Wall Street Journal acknowledged in spite being lower in numbers, some larger banks controlled most assets. Accordingly, the Journal changed the method for the prime rate that is published now. The Journal’s rate at present now reflects the base rate post by at least 70% of the top ten banks by assets.
The prime rate index is typically referred while calculating rate changes to adjustable rate mortgages (ARM) and other variable rate short term loans. It is also referred in the calculation of some private student loans. Many credit cards and home equity lines of credit that carry variable interest rates have their rate defined as the prime rate (index) plus a fixed value commonly called the spread or margin.