What Is the Prime Interest Rate?

The prime interest rate is the percentage that U.S. commercial banks charge their most creditworthy customers for loans. Like all loan rates, the prime interest rate is derived from the federal funds' overnight rate, set by the Federal Reserve at meetings held eight times a year. The prime interest rate is the benchmark banks and other lenders use when setting their interest rates for every category of loan from credit cards to car loans and mortgages.

At the end of 2023, the prime interest rate was 8.5%. The federal funds rate at that time was set at 5.25 to 5.50%.

How the Prime Rate Works

An interest rate is the percentage of a loan amount that a lender charges. It is the lender's compensation, and the percentage varies with each type of loan. Generally, any unsecured loan such as a credit card balance is charged interest at a higher rate than a secured loan such as an auto loan or a mortgage. The rate that an individual or business receives will vary depending on the borrower’s credit history and other financial details.

These rates are normally defined as an annual percentage rate (APR).

The Federal Funds Rate

The prime interest rate, which is also called the prime lending rate, is largely determined by the federal funds rate set by the Federal Open Market Committee (FOMC) of the Federal Reserve.

The fed funds rate is the overnight rate banks and other financial institutions use to lend money to each other. The process is a constant electronic flow of money that ensures that each bank has sufficient liquidity to operate from day to day.

The Prime Rate

Banks generally use a formula of federal funds rate + 3 to determine the prime rate it charges its best customers, primarily large corporations that borrow and repay loans on a more or less constant basis.

That prime rate is the starting point for all other interest rates, which are set at the prime rate plus an additional percentage.

The bank sets a range of interest rates for each loan type. The rates individual borrowers are charged are based on their credit scores, income, and current debts.

For example, a person with an outstanding credit score might be charged, say, prime plus 9% for a credit card, while an individual with only a good score might get a rate of prime plus 15%.

Determining the Prime Rate

The prime rate is determined by individual banks and used as the base rate for many types of loans, including loans to small businesses and credit cards. The Federal Reserve has no direct role in setting the prime rate, but most financial institutions choose to set their prime rates based partly on the target level of the federal funds rate established by the FOMC.

One of the most used prime rates is the one that The Wall Street Journal publishes daily. As noted above, banks generally use fed funds + 3 to determine the prime rate.

The prime rate in the United States as of early February 2024 is 8.5%, as it has been since July 27, 2023. At that time, the fed funds rate was set at a target of between 5.25% and 5.5%.

The prime rate had increased since May 2022, moving in tandem with the FOMC's increases to the fed funds rate to combat high inflation.

Although other U.S. financial services institutions regularly note any changes that the Fed makes to its prime rate and may use them to justify changes to its prime rates, institutions are not required to change their prime rates following the Fed's decisions.

What Is the Impact of the Prime Rate?

The prime rate affects a variety of bank loans. When the prime rate goes up, so does the cost to obtain small business loans, lines of credit, car loans, mortgages, and credit cards.

Debt with a variable interest rate can be affected by the prime rate because a bank can change your rate. This includes credit cards as well as variable rate mortgages, home equity loans, personal loans, and variable interest rate student loans.

The prime rate is reserved for only the most qualified customers, those who pose the least amount of default risk. If the prime rate is set at 5%, a lender still may offer rates below 5% to well-qualified customers.

How Does the Prime Rate Affect Borrowers?

The prime rate is not fixed and can change over time based on changes in the federal funds rate, inflation, the demand for loans, and other economic factors. When the prime rate changes, the interest rates on loans and financial products that are based on the prime rate may also change. The prime rate can affect you in different ways, depending on the type of loan or financial product you have. Here are some of the most common ways:

1. Home equity loans. If a borrower has a home equity loan or home equity line of credit (HELOC), the interest rate on the loan may be based on the prime rate. If the prime rate increases, the interest rate on the home equity loan may also increase, leading to higher monthly payments for the borrower.
2. Adjustable-rate mortgages (ARMs). If a borrower has an ARM that is tied to the prime rate, an increase in the prime rate may lead to an increase in the interest rate on the mortgage, resulting in higher monthly payments for the borrower.
3. Credit card balances. If a borrower has a credit card with a variable interest rate, the interest rate may be based on the prime rate. If the prime rate increases, the interest rate on new purchases using the credit card may also increase, leading to higher interest charges for the borrower.
4. Small business loans. If a small business has a loan with an interest rate based on the prime rate, an increase in the prime rate may lead to an increase in the interest rate on the loan, resulting in higher loan payments for the business.

History of the Prime Rate

The prime rate dates back to the 1930s when banks first used it to set interest rates for short-term lending to their most creditworthy customers following the Great Depression. In the decades following World War II, the prime rate remained relatively stable, hovering around 2% to 3%.

The prime rate began to rise significantly in the 1970s as the United States experienced an economic recession and high inflation. The prime rate reached its all-time high of 21.5% in Dec. 1980, as the Federal Reserve sought to curb inflation by raising interest rates.

Over the next few decades, the prime rate fluctuated widely, reflecting the ups and downs of the economy and largely mirroring other benchmark interest rates. During times of economic growth, the prime rate tends to be higher, while it tends to be lower during times of recession or financial turmoil.

The Bottom Line

The prime rate is the interest rate that commercial banks charge creditworthy customers and is based on the Federal Reserve's federal funds overnight rate.

Banks generally use fed funds + 3 to determine the current prime rate. The rate forms the basis for other interest rates, including rates for mortgages, small business loans, or personal loans.