How Does the Key Interest Rate Compare to a Prime Rate?

The key interest rate that controls the prime rate is known as the overnight fed funds rate. This key rate is the interest rate that banks lend and borrow money at between each other. On the other hand, the prime rate is the best rate at which banks lend money to their most creditworthy borrowers. The relationship between the fed funds rate and the prime rate is very direct and changes in proportion to each other.

Fed Funds Rate

Overnight fed funds represent loans made from one bank to another.

The key rate used for comparative purposes with the prime rate is the fed funds rate. This rate is controlled by the Federal Reserve Bank and represents the rate that banks charge each other for overnight lending and borrowing of money. For example, if one bank temporarily needs money, it will borrow from a bank that it has an established relationship with that has excess funds to loan. These overnight fed funds must be paid back to the lending bank on the very next business day.

Prime Rate

The prime rate is the best rate that a bank can offer to its most creditworthy and profitable customers.

The prime rate is the best rate at which banks lend money to their most creditworthy customers. These customers are usually the largest business or individual relationship accounts that provide the most profit to the bank. They also possess very good credit ratings and have a good history with the bank over a longer period of time. They are considered to be the core relationships that the banks can least afford to lose.

Comparison

The prime rate moves in the same direction and amount as the overnight fed funds rate.

The key overnight federal funds rate serves as the cost basis for the prime rate. This key rate will change as the Federal Reserve Bank changes the rate. On the other hand, the prime rate will move in the exact direction and proportion as compared to changes in the fed funds rate. Almost all banks offer the same prime rate within the same time frame. The prime rate is based on the current fed funds rate plus 3 percent. Therefore, a fed funds rate of 2 percent will equate to a prime rate of 5 percent (i.e., 2 percent plus 3 percent equals 5 percent).

Monetary Policy

The Federal Reserve Bank's entire purpose for controlling the key overnight fed funds rate is to increase or decrease growth by lowering or increasing the rate, which automatically lowers or increases the prime rate. When the fed funds rate is lowered, the prime rate is reduced, which creates the demand for borrowing. On the other hand, when the economy is strong and inflation is prevalent, the key rate will increase, which has the same effect upon the prime rate. This relationship between the key rate and the prime rate is part of U.S. monetary policy.

Prime Rate Relationship

As the overnight fed funds rate changes, the prime rate also changes.

As the prime rate increases or decreases due to its relationship with the overnight fed funds rate, many other credit rates based on the prime rate increase or decrease. Different types of commercial, industrial and consumer loans are tied to the prime rate plus a percentage spread. For example, a commercial loan may be based upon the prime rate plus 3 percent. Therefore, if the prime rate is at 5 percent, then the commercial loan under evaluation would be priced at 8 percent (i.e., 5 percent plus 3 percent equals 8 percent). In short, the change in the overnight fed funds rate changes the prime rate but also extends to many other types of loans based upon the prime rate.

References

• Wall Street Journal: The Fed (U.S.) Prime Rate
• Money Cafe: Prime rate
• Articles Base: How the Prime Rate Works

Resources

• Federal Reserve Bank of San Francisco: What is the prime rate and who borrows at that interest rate?