Prime Rate

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 –

Prime-Rate

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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:

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:

Prime Rate Chart

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

Why it’s Important?

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