DEFINITION: The phrase “prime rate” is short for the expression “prime lending rate,” meaning the interest rate at which banks lend money to their best customers—that is, their customers with an excellent or “prime” credit rating.
While, generally speaking, the prime rate is set by the marketplace (borrowers seeking the lowest rate they can find), it is also strongly influenced by the federal funds rate, which is set by the US Federal Reserve System, better known as “the Fed.”
ETYMOLOGY: The word “prime” derives, via Middle English, from the Latin word prīmus, meaning “first.”
The word “rate” derives, via Middle English, Middle French, and Medieval Latin, from the Latin deponent verb reor, rēri, meaning “to reckon.” More specifically, “rate” derives from the past participle, ratus, of the aforesaid verb, meaning “reckoned,” “determined,” or “fixed.”
USAGE: The prime rate serves primarily as a benchmark or index for use in the calculation of interest rate changes in several categories of short-term, variable-rate consumer loans, notably adjustable-rate mortgages (ARMs) and other variable-rate loans (see below).
The prime rate is also the basis for the calculation of many privately funded student loans.
Perhaps the largest category of variable-rate consumer loans consists of those with interest rates that are tied directly to the prime rate, plus a fixed amount known as “the margin” or “the spread.”
The familiar categories of consumer products which are structured in this way include most credit card lines of credit and home-equity loans and lines of credit.
In the US, the prime rate has been historically set around three percentage points above the federal funds rate. Some of the most important foreign countries have analogous institutions, such as the UK’s London Inter-Bank Offered Rate (LIBOR).
Before 2008, it was common practice in the US for the Wall Street Journal (WSJ) to update its published prime rate when 23 out of the 30 largest banks in the US changed their prime rates.
However, since the financial crisis of 2008, and partly in recognition of the fact that fewer banks now control the majority of all banking assets, the WSJ now publishes a prime rate reflecting the rates posted by 70 percent of the ten largest banks in the US.