The prime rate, when used by an individual bank, is the interest rate that an individual bank charges its most credit-worthy customers on short-term loans. In the U.S., the term more commonly refers to an index issued by the Federal Reserve. It is found by taking the majority prime rate of the 25 to 30 largest domestic banks. The Federal Reserve has been in existence since 1913, but the prime rate index has been accurately assessed only since 1949.
Before the 1970s
Before the 1970s, banks used the prime rate index primarily for lending to commercial interests. The most credit-worthy customers would receive short-term loans at prime.
Peak in 1980
Paul Volcker was sworn in as the Federal Reserve chairman in August 1979 and promptly raised the federal funds rate to reduce the money supply, thus curtailing inflation. The prime rate peaked in December 1980, reaching a record 21.5 percent. Though the strategy was painful to workers, business owners and consumers, it ultimately ended a long inflationary period.
Historical Link to Federal Funds Rate
The prime interest rate index historically has been closely tied to the federal funds rate (FFR), the interest rate at which banks lend to each other, usually overnight, to meet statutory Federal Reserve requirements. The prime rate historically has been about 2 percent to 3 percent above the FFR to allow for a fair return on banks' capital and the higher risk of lending to corporations over a period of months as opposed to lending to other banks overnight.
A shift toward noncommercial use
By the end of the 1980s, the use of the prime rate index had expanded from pricing business loans to pricing products for homeowners and other consumers.
Lenders want to float interest rates for longer-term loans to protect against lost income if rates go up. However, the basis of the interest rate had to be widely verifiable, stable and viewed as fair. The prime rate index was then used increasingly in retail products as a solution to these needs. For example, a home equity loan's interest rate would be stated as prime plus 2 percent.
The prime rate index then gained increasing use in credit card interest rates at the turn of the millennium. The reason for this last move was to capitalize on anticipated rate increases expected after long stretches of low interest rates. Lenders prefer fixed rates when future rates are expected to be lower, and variable rates when future rates are expected to be higher.
Therefore, low interest rates in the past few years led to an increase in the issuing of variable-rate credit cards. The prime rate was a useful index to market such products. Beyond that, the threat of laws limiting the ability to raise interest rates compelled lenders to utilize an anticipated loophole, allowing use of the prime rate index to avoid absolute limits mandated by law.