The prime rate is a base rate that banks use to set the interest rate on many of their commercial loan and consumer loan products. The term originally identified the classification of a prime customer as one considered to be the banks most credit worthy customer. The default risk of a borrower, whether it be a business of consumer, is the main factor used to determine the interest rate a bank will charge that borrower. Because a bank’s best customers have little chance of defaulting, the bank can charge them a rate that is lower than the rate that would be charged to a customer who has a higher likelihood of defaulting on a loan.

Each bank establishes the prime rate independently. Over short periods of time, the prime rate is often very similar across all banks. While individual banks may change their prime rate at any time depending on market conditions, the prime rate tends to move closely in line with market interest rates and the cost of bank funds. This is unlike deposit interest rates banks pay, which often vary considerably from bank to bank depending on funding needs and portfolio considerations.

In recent years more consumer loan products also have been priced off of the prime rate including credit cards and home equity lines of credit. Interest rates on these adjustable interest rate loan products change with a published prime rate index, like the one published daily in the Wall Street Journal.

Consumer borrowing for home loans or for credit cards with a floating interest rates likely follow the prime rate. Businesses taking out commercial loans are often priced off of the prime rate. The prime rate very closely follows other short-term interest rates, such as the overnight federal funds rate and short-term U.S treasury rates. Knowing what the prime rate is and how it perform over time is important to understanding the influences of short term lending and savings interest rates in banking and the financial marketplace.

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