Banks typically offer their most creditworthy business customers, such as large corporations, a low short-term loan interest rate, at or close to the prime rate. When people speak of a prime rate, they usually mean an average of the prime interest rates set by large banks, as reported each day by the Wall Street Journal. For the consumer, the prime rate is of more than academic interest because it directly affects the cost of borrowing for individuals.
How the Prime Rate Works
Banks determine the interest rates they charge according to how much it costs them to borrow money. Normally, a bank bases its prime rate on the federal funds rate set by the Federal Reserve Board. The federal funds rate is the interest rate the Federal Reserve depository institutions set for banks to lend money overnight to one another, and banks can choose how much to mark this rate up when making loans to other banks. According to FedPrimeRate.com, the prime rate is typically equal to the federal funds rate plus 3 percent. For example, in June of 2015 the federal funds rate was zero to 0.25 percent and the prime rate was 3.25 percent.
The WSJ Prime Rate
The Wall Street Journal Prime Rate is the most widely used measure of national prime rates. The WSJ Prime Rate is the average of the prime rates charged by the 10 largest banks. When seven of the 10 banks change their prime rates, the WSJ Prime Rate is updated to reflect the change.
Prime Rate History
When the Wall Street Journal started publishing its index of the prime rate in 1947, it used an average of 30 bank prime rates. This was changed to an average of the rates posted by the 10 largest U.S. banks in December, 2008. The prime rate stood at 1.75 percent in 1947. Over the years it fluctuated, but skyrocketed to an all-time high of 21.5 percent in December, 1980. The 21st century opened with the prime at 9 percent in January, 2001. It declined to 4 percent in June of 2003.
After climbing to 8.25 percent in June, 2006, the prime fell to 3.25 percent in December, 2008. As of July, 2015 the WSJ Prime Rate has continued to hold steady at 3.25 percent.
Significance of the Prime Rate
Changes in the prime rate have a big impact on the cost of borrowing money. If the prime rate goes up, banks must pay more for money and so have to charge consumers and businesses higher interest rates. Conversely, money becomes cheaper when the prime dips and banks can lower interest rates. Variable interest rates on consumer loans like mortgages and credit cards are often tied directly to the prime rate. For example: Suppose you take out an adjustable rate mortgage that specifies the interest rate is equal to the prime rate plus 3 percent. When the prime rate is 3.25 percent, your interest rate is 6.25 percent. If the prime increases to 4 percent, your mortgage interest rate goes up to 7.25 percent and your monthly payments increase.