 Ask
Dr. Econ
June 2005
What is the prime rate, and who borrows at that interest rate?
This is an interesting question for many borrowers.
The prime rate is a “reference or base rate” that banks use
to set the price or interest rate on many of their commercial loans and
some of their consumer loan products. The prime rate tracks fairly closely
with other short-term interest rates, such as the overnight federal funds
rate; this relationship is illustrated in Chart I. As of June 2005, the
bank prime rate reported on the Federal Reserve Board’s monthly
H.15 Release, Selected
Interest Rates,
was 6.01 percent.
The prime rate is a short-term interest rate
The prime rate shown in Chart I is the interest rate charged by the
majority of the nation’s top 25 domestic commercial banks. One
interesting feature is that the prevailing prime rate typically is uniform
across all banks—unlike deposit interest rates banks pay, which
often vary considerably from bank to bank depending on funding needs
and portfolio considerations. While individual banks may change their
prime rate at any time depending on market conditions, the prime rate
tends to move closely in line with market interest rates. As is illustrated
in Chart I, the prime rate (heavy red line) very closely follows the
federal funds rate (thin blue line), the interest rate that banks charge
each other on overnight interbank loans.
Chart I
The Prime Rate and the Federal Funds Rate Move Together
How important is the prime rate for business lending?
The prime rate remains an important reference rate for commercial banks,
although its use has changed over time. (See “The
Persistence of the Prime Rate,” FRBSF Weekly Letter (5/20/94))
The quarterly Federal Reserve statistical release, E.2, Survey
of Terms of Business
Lending,
provides information on commercial and industrial loan lending terms,
including information on the share of value of loans priced off of the
prime rate.
According to the May 2-6, 2005 Survey, about one-third of the value
of all commercial loans made by the banks surveyed were priced off of
the prime rate. The survey also provides information on the weighted
average effective loan rate for loans with a variety of characteristics.
However, the share of loans priced off of the prime rate varied significantly
according to a number of factors including the type and size of bank
making the loan, the size and maturity of the loan, how the loan was
priced, and whether the loan was secured by collateral. So, which banks
typically tie loans to the prime rate and which types of loans are likely
to be priced off of the prime rate?
- Small domestic banks
The May 2-6, 2005 Survey indicated that domestic banks, particularly
small ones, were more likely to price loans off of the prime rate.
U.S. Agencies and Branches of Foreign Banks rarely priced loans
off the prime rate—these institutions would typically price
loans off of London Interbank Offer Rate (LIBOR) or other money
market interest
rates.
- Smaller business loans, floating rate loans, collateralized
loans
Smaller business loans tend to be referenced to the prime rate; at
domestic banks, over 70 percent of the value of loans under $1 million
in size
were prime based. In the aggregate, more than 75 percent of the value
of all floating rate business loans were tied to the prime rate.
Prime-based loans were about twice as likely to be secured by collateral
as other
business loan pricing options.
- Consumer loans
In recent years more consumer loan products also have been priced
off of the prime rate including credit cards and home equity lines
of credit.
Interest rates on these adjustable interest rate loan products
change with a published prime rate index, like the one published
daily in
the Wall Street Journal.
Sources of prime rate data
So, whether you are a consumer borrowing against your home or on your
credit card with a floating interest rate like the prime rate, or a business-owner
taking out a commercial loan priced off of the prime rate, knowing what
the prime rate is and how it behaves over time is important to your financial
well being. You can find historical information on the prime rate and
other interest rates at the H.15 historical index page on the Federal
Reserve Board’s website.
Additionally, you may go to FRED,
the Federal Reserve Bank of St. Louis’s
database website and download prime rate
data or create a chart showing the behavior of the prime rate over a
period of several years.
Consumer Credit (G.19)
Selected Interest Rates (Weekly) (H.15)
Survey of Terms of Bank Lending (E.2)
Federal
Reserve Bank of St. Louis. Website, see Economic Data – FRED.
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