The term "Prime Lending Rate" might sound new to many of the readers here, but each one of you needs to know what exactly it means! So, let's begin and learn everything about Prime Lending Rate precisely.
Prime Lending Rate, also known as Prime Rate or Prime Interest Rate, is the interest rate that large Commercial Banks charge on the loans and products held by their most reliable customers. Reliable customers here means the customers with the highest credit rating. Generally, the customers with high creditworthiness are large corporations that are borrowing funds from Commercial Banks with a view to finance their operations with debt.
In other words, we can say that Prime Lending Rate is the interest rate that banks usually charge their most preferred customers, i.e. Least risky borrowers or those with the highest credit ratings. The reason behind this is banks know that their creditworthy customers are the least likely to default. Though civilians hardly ever qualify for the Prime Lending Rate on loans, the Prime Rate sets a benchmark for other kinds of interest rates, involving short-term loans, student loans, business loans etc. Talking about the Prime Rate index, the Prime Rate index can be volatile or remain persistent for months on end, depending entirely on the economic climate.
The Target Federal Funds rate, set by the Federal Reserve Board, serves as the basis for the Prime Lending Rate. The Federal Funds Rate is the interest rate Commercial Banks charge each other for overnight lending of funds. In general, the Prime Interest Rate or Prime Rate is about 3% higher than the Federal Funds Rate. This means that when the Federal Funds Rate increases, the Prime Lending Rate also goes up.
As stated above, banks use the Prime Interest Rate to set the interest rates on multiple short-term loan products. These products involve auto loans, adjustable-rate mortgages, credit cards and home equity loans. The terms of these loans are expressed as Prime plus a certain percentage that depends on the credit rating of the borrower and other factors.
This was all about what Prime Lending Rate is! Now, let's move ahead and look at the breakdown of the Prime Interest Rate.
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Breaking down Prime Lending Rate
Commercial banks generally charge a Prime Lending Rate that works perfectly with their individualised set of customers. This means that there are many different rates charged across an economy. Because of this practice, the single rate figures are the average of the number of Prime Interest Rates charged by multiple major Commercial Banks.
Since Prime Rates are charged to the most reliable and creditworthy customers of the bank, they are usually lower than the interest rates charged to normal individuals who are more prone to default. Despite being of concern to large corporations, Prime Lending Rates can also affect the interest of individuals in a society because the rates can affect the interest rates charged on other products like loans for SMEs etc.
In case the top customers of the Commercial Banks see their credit decrease, it can be a major indicator of the downward pressure placed by the economic climate on all borrowers of the bank. Therefore, the interest rate charges for personal loans or mortgages will likely react to a hike in the Prime Lending Rate.
How Does the Prime Lending Rate Work?
The Prime Lending Rate, also known as the Prime Interest Rate, is the lowest interest rate that a Commercial Bank can offer to a borrower on a line of credit or loan. The banks offer a lower interest rate on loans to customers with the least risk of defaulting on their loans because there is less risk to mitigate. This Prime Lending Rate acts as a benchmark interest rate for the biggest and lowest risk borrowers of a bank.
Besides this, large corporate borrowers can also affect the Prime Lending rate on the basis of the strategy they employ for their capital structure. Any company or corporation can make itself more creditworthy by paying off its debt and resorting more to equity to finance its operations and projects. While funding with equity comes with its own pros and cons when compared to debt financing, both these sources are popularly used by the majority of large companies.
All financial institutions set their own Prime Lending Rates; therefore, there is no single Prime Interest Rate. For your information, the Prime Interest Rate usually doesn't drop below 3.25%, thus making it the base interest rate for the banks lending to large corporate borrowers.
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Relation between Prime Rate and Overnight Rate
As discussed above, the Prime Lending Rate is heavily dependent on the Federal Rate, also known as the Overnight Rate. The Overnight Rate is the rate of interest that banks charge on money lent to other banks, which are considered the most creditworthy entities in an economy, next only to the government.
If the Overnight Rate goes up, it can indicate that Commercial banks see their credit decrease. And, if the creditworthiness of the most creditworthy entities in an economy is going down, it is a clear indication that the overall economy is declining. As a consequence, the Prime Rate is likely to go up since the large corporations might also be facing more difficult economic conditions.
Such circumstances might affect the ability of large corporations to pay off existing debt, which in turn puts downward pressure on their credit scores and finally results in an increase in the Prime Lending Rate.
That's all! We hope this article has helped you understand what Prime Rate is, how it is related to Overnight Rate and much more. If you have any questions related to Prime Interest Rate, you can drop a comment below, and we will be more than happy to answer your queries.