What Is a Prime Lending Rate?

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By Kent Ninomiya
eHow Contributing Writer

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The prime lending rate is the interest rate that banks charge their best clients to lend them money. These clients are usually established business people with excellent credit and a long history of successful transactions with the bank. As a result, this is the lowest interest rate a bank charges at any given time. The prime lending rate fluctuates in relation to the fed funds rate from the Federal Reserve Bank.

Significance

The prime lending rate is used to determine adjustable rate mortgages, home equity lines of credit, auto loans, personal loans, business loans and interest rates of credit cards. These interest rates are always higher than the prime lending rate because people using these financial products usually do not have the same credit worthiness as a business being charged the prime lending rate. The interest rates for these other types of loans move up and down relative to the prime lending rate.

Identification

The prime lending rate changes relative to the fed funds rate. This is the rate banks charge to lend money to each other. It is set by the Federal Open Market Committee to help regulate the economy. When the FOMC lowers the fed funds rate, money is cheaper to borrow and there is theoretically more economic activity. When the FOMC raises the fed funds rate, money costs more to borrow and the economy slows down. The prime lending rate usually adjusts whenever the fed funds rate does.

Features

The prime lending rate is usually maintained at about 3 percent above the federal funds rate. Since the federal funds rate is the cost banks pay to borrow money from other banks, the 3 percent "spread" allows for the bank's profit when they loan the money to their best customers at the prime lending rate.

Effects

Some adjustable rate mortgages are set up to charge interest at a set amount above the prime lending rate. This is an additional "spread" that the lending financial institution gets from their less reliable customers. For example, terms of an adjustable rate mortgage can state that on a specified date the interest rate will adjust to one half of a percent above the prime lending rate. If the prime lending rate went up, the loan payer will be charged more to maintain the loan. If the prime lending rate dropped, the loan payer may be charged less. Adjustable rate loans usually establish minimum interest rates regardless of how low the prime lending rate falls.

Function

Most financial professionals track the prime lending rate by watching the Wall Street Journal Prime Rate compiled by the "Wall Street Journal" newspaper. It is an index of prime lending rates charged by the 30 largest banks around the country. When 75 percent of them change their prime lending rate, the Wall Street Journal Prime Rate changes.