Prime rate is a term applied to a reference an interest rate that is utilized by banks and financial institutions for lending purposes.

The prime rate was a term originally used to identify the rate at which banks lend to their best and most favored customers, though this is no longer the case in general. The prime rate is a rate that is determined by each individual bank or financial institution. Though the rate will vary by only small increments between different banks, each institution nonetheless establishes the rate independently. The government or the various agencies that regulate financial institutions do not establish or set the prime rate.

Financial products that are based on the prime rate are usually based on an index that takes an average of a number of banks established prime rate. The single most generally accepted measure of the prime rate is the Wall Street Journal Prime Rate. The Wall Street Journal surveys largest banks and publishes the consensus prime rate. The Wall Street Journal looks at a certain number of the largest banks, and when three-quarters of them change their rate, the Wall Street Journal changes its rate, effective on the day the Journal publishes the new rate.

More often the prime rate is set at approximately 300 basis points above the Federal Funds Target Rate set by the Federal Reserve, the central bank of the United States. Other institutions base the Prime Rate on the movements of the London Inter-bank Offer Rate, or LIBOR. The prime rate will move up and down with the general direction of overall lending rates. The Fed Funds Rate and LIBOR rate are merely other lending rates which indicate the overall direction or position of short term borrowing.

So, the Prime Rate isn’t one thing for all institutions, but it does not differ much from one to another.

The prime rate is used often as an index in calculating rate changes to adjustable rate mortgages (ARM) and other variable rate short-term loans. It is used in the calculation of some private student loans. Many credit cards with variable interest rates have their rate specified as the prime rate (index) plus a fixed value commonly called the spread. Some variable interest rates may be expressed as a percentage above or below prime rate.

Many adjustable rate mortgages and other consumer debts are tied directly to the rate as quoted in the Wall Stret Journal because the Wall Street Journal is readily available to most people on a daily basis by purchase or in a library or office.

So, on a variable rate mortgage where the payment is due on the first of each month, the rate for that month may be determined by the change in the prime rate as quoted in the Wall Street Journal on some arbitrary date set forth in the mortgage agreement, for example, the third Thursday of each month. If the Journal reports a drop in the prime rate between the third Thursday of April and the third Thursday of May, for example, the mortgage payment due on June 1st will drop a similar percentage rate.

The same kind of adjustments are also made on the rates for credit card balances, for example, although it is important to note that in all cases the rate is seldom the prime rate itself, but the prime rate plus or minus some other percentage. So, if the prime rate drops one-half of one percent in response to a drop in the Federal Funds Rate, your credit card rate may drop too.

More specifically, if the Federal Funds rate drops from 4.5% to $4.0% the Prime will likely drop from 7.5% to 7.0%, and your credit card interest rate may drop from 12.5% to 12.0% if your credit card balance is charged at a rate that is 5.0% above Prime. Please note that banks and credit cards are not obligated by law to change their rates, but generally do so for competitive or other strategic reasons. The rate changes may not correspond 1 to 1 with the other rates changes and the time between changes may be lengthy.

While a drop in the prime rate may be good for adjustable rate mortgage payers and credit card holders, interest rate sensitive investments will also be affected. If you are about to roll over a Certificate of Deposit or make a change in some other money investment, check to see what direction rates are moving. You may receive a better interest rate on a Wednesday than you do on a Thursday if the Wall Street Journal reports a drop in the Prime Rate.

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