Prime Rate
What is Prime Rate?
The prime rate is the benchmark interest rate banks charge their most creditworthy customers; it tracks the federal funds rate, usually running about 3 percentage points above it.
Banks set the prime rate themselves, but they peg it to the FOMC's federal funds target, so when the Fed moves rates the prime rate moves with them. Many consumer and small-business loans (credit cards, HELOCs, variable loans) are priced as 'prime plus a margin,' which is how Fed policy reaches everyday borrowers. The prime rate is not set by the Fed directly.
Prime Rate: a worked example
Suppose the federal funds target sits at 4%, so banks post a prime rate of 4% + 3% = 7%. Delgado Landscaping holds a $150,000 line of credit priced at prime plus 2, meaning 9%, and pays 0.09 x $150,000 = $13,500 in annual interest. The FOMC then raises the funds target by 0.75 points to 4.75%. Prime moves to 7.75%, the line reprices to 9.75%, and annual interest becomes 0.0975 x $150,000 = $14,625. Delgado pays $1,125 more per year without renegotiating a thing, because the margin over prime never changed.
The mistake students make with prime rate
Many people say the Fed sets the prime rate. It does not; each bank posts its own prime, and the number moves only because banks peg it to the FOMC's federal funds target and adjust within a day or two of a decision. The error is tempting because prime changes hit the news right after Fed meetings, which reads like an announcement. The distinction matters: nothing forces a bank to move prime or to keep the usual three point gap.
Prime Rate questions
Who sets the prime rate?
The prime rate is set by commercial banks individually, not by the Federal Reserve. Each bank publishes the rate it charges its strongest borrowers, and because they all peg it to the same federal funds target, the posted rates converge on one national number. When the FOMC moves its target, banks reprice prime within days, which is why the two appear inseparable.
How does the prime rate affect credit card rates?
The prime rate is the base for most variable credit card and home equity rates, which are quoted as prime plus a margin. A card at prime plus 12 with prime at 7% charges 19%. If prime rises to 8%, the card charges 20% on the next statement, because the margin written into the contract is fixed and only the index moved.
What does prime plus 2 mean on a loan?
Prime plus 2 means the loan's rate equals the current prime rate plus 2 percentage points. With prime at 7%, the borrower pays 9%; if prime falls to 6%, the borrower pays 8% with no renegotiation. The size of the margin reflects how much riskier the borrower looks than a bank's strongest customers, so a weaker applicant might be quoted prime plus 6 instead.
Formula / Example
Related terms
Common comparisons
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated