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Wednesday, January 12, 2011

The significance of prime rate

 

The “prime rate” or “prime interest rate” is the interest rate that historically was the low rate banks would offer to their most credit-worthy customers. However, this is not the case today. The term “prime rate” is generic but usually refers to the Wall Street Journal Prime Rate, which the paper posts daily.

The rate varies little among major banks; adjustments are generally made by banks at the same time — when the Federal Reserve Bank changes the Fed Funds Target Rate. The last time the prime rate was adjusted was two years ago, when it dropped from 4 percent to 3.25 percent. 2010 rates are notably historic given that the prime rate hasn’t been this low since Aug. 4, 1955 (55 years ago).

This current rate of 3.25 percent, in the United States, runs approximately 300 basis points (3 percent) above the federal funds rate, which is the interest rate that banks charge each other for overnight loans made to fulfill reserve funding requirements.

The prime rate is used often as an index in calculating rate changes to adjustable rate mortgages (ARM) and other variable rate short-term loans.

It is also used in the calculation of some private student loans. Many credit cards and home equity lines of credit with variable interest rates have their rate specified as the prime rate (the so-called index) plus a fixed value commonly called the spread or margin.

The significance of the prime rate is important since it is often used as an index by lenders for the rates they use to lend to their borrowers. Adjustments to this rate affect many parties. For example, the holder of an adjustable-rate mortgage or a home equity credit line pegged to the prime rate will pay more as the prime rate moves up and less as it moves down.

 

Robert Vreeland is a senior vice president specializing in Commercial Construction Loans with Commerce Bank of Arizona, an Arizona based community bank specializing in serving small to mid-size businesses in Arizona.  He can be reached by phone at (520) 382-5570 or e-mail: rvreeland@commercebankaz.com

 

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