What is Prime Rate?
Prime Rate (also known as Prime Lending Rate i.e. PLR) is the basic interest rate, fixed by committee constituted by the Central Bank of the country, that is charged between commercial banks (i.e. charged by the lending bank to the borrowing bank) and it forms basis for interest rates on business loans, personal loans, vehicle loans, home loans, mortgages, etc.
Explanation
Suppose you take a home loan from a commercial bankCommercial BankA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits.read more at an interest rate of 7% per annum with the tenor of 15 years. Have you ever thought what this 7% comprises of? Let’s dig into the same –
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For eg:
Source: Prime Rate (wallstreetmojo.com)
Interest Rate to Charged = Prime Rate + Risk Premium + Inflation Premium
Let’s assume the following figures:
- Prime Rate = 3%
- Risk Premium = 2% (Risk PremiumRisk PremiumRisk Premium, also known as Default Risk Premium, is the expected rate of return that the investors receive for their high-risk investment. You can calculate it by deducting the Risk-Free Investment Return from the Actual Investment Return. read more is the extra interest charged upon various factors such as the creditworthiness of the customer, income factors, growth factors, the value of a home, etc.)
- Inflation Premium = 2% (Inflation Premium is charged on the basis inflation situations around the country)
That makes the interest rate charges by the bank to you. So, we were talking about the basic charge i.e., the prime rate. If you see, most creditworthy customers are not charged with the risk premium. In that case, the interest rate goes with Prime Rate + little margin.
It is decided as follows –
Prime Rate = Feds Target Rate + 3% Usually
Federal funds target rate is the benchmark rate decided by a committee every six weeks. If the Feds Target rate changes, the prime rate also changes. Due to the global chaos caused by the Chinese Virus – Novel Corona Virus, the current target rate decided by the Fed is around 0 to 0.25%. Thus, currently, this is trading at 3.25% as of March 15, 2020.
The historical prime rates are as follows:
Determining the Prime Rate
- Every bank has its right to decide its own rate. However, each bank has to keep the lending rate near to the prime rate.
- As said earlier, firstly, the committee decides the base rate i.e., Federal Funds Target Rate (which currently is 0 to 0.25%). After deciding the same, each bank uses it as a base for deciding the prime lending rate.
- For deciding this rate, banks consider the minimum default risk amongst the customers. Bank would charge lower for lower default high & vice-versa.
- So, you can now guess that there is no single rate as such & it is usually the average rate charged by the largest banks.
Who Sets It?
- Firstly, the FOMC (i.e., Federal Open Market Committee) is the authority to decide the base rate i.e., the Federal fund’s target rate. It meets every six weeks & in such meeting, it is decided whether to or not to change the base rate. If the base rate changes, the prime rate changes accordingly.
- The banks then come into play to decide the prime rate to prevail.
Uses
- Since the base rate is the same, it helps to compare the interest rates offered by two banking institutions. Thus, it helps in deciding the business person whether to borrow from Bank A or Bank B.
- It helps identify the riskier assets of the bank i.e., those loans where the bank has charged a higher interest rate as compared to others.
- It helps banks determine the rate they can offer to the deposit holders so that they can decide on their profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more.
- It helps to keep inflation under the control of the government.
- It forms the basis for the other loan products offered by the bank. Thus, this assures the minimum revenue for banks.
Why it’s Important?
- The interest rate charged by the bank is primarily based on the prime rate & then a little margin over it. So, you can see that all products of any bank, let it be mortgages, balance transfer cases, credit cards, etc. are all based on this rate.
- Thus, when the Federal Open Market Committee increases or decreases the base rate, the consequential prime rate will change & thereby, it changes the variable interest rates offered on the products. That’s how this rate is important for any financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more.
- This is the ultimate rate which changes the minimum amount that will be due on your credit card usage, the Equated-Monthly-Installments, the principal component from your EMIs, the interest rate on mortgages, even on the student loans & whatnot.
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