Prime Interest Rate: How To Calculate The Real One
Prime interest rate: Prime interest rate is the rate of interest most financial lenders charge their credit worthy or highly valued clients. This rate of interest varies little between banks and a revision of the same is usually made by the lenders at roughly the same time. This prime interest rate is used as a guide or benchmark to determine the interest rate of other financial products such as home equity, mortgage among other forms of loans. In some situations, the prime rate is used to determine the rate at which lenders give out student loans. Furthermore, most credit card companies use the prime rate to determine the rate of interest on their cards.
In most banks, only a small portion of clients are offered this interest rate. Despite this, many people have developed an interest on it since most financial institutions rely on this rate to determine interest rates on some of their financial instruments. The prime interest rate is affected by other interest rates that are set by the Federal Reserve for instance the discount rate and the Fed Funds rate. However, the Federal Reserve does not set the prime interest rate. The discount rate is the rate at which depository institutions borrow money from the regional Federal banks. On the other hand, the Fed Funds is the rate of interest that federal depository institutions use to lend money to each other.
Under normal situations, the prime rate of interest is set at an approximate value of 300 points or 3 % above the Fed funds rate of interest, which is the rate commercial banks use for lending overnight loans to each other. The discount interest rate, which is established by the FOMC or the Federal Open Market Committee, is used to determine the Fed funds rate. This committee usually meets periodically where they determine a target for the Fed funds rate. Other interest rates, prime rate included, are then derived from this rate at 3 % higher.
Financial institutions usually prefer to give the Prime Rate to large corporations because they perceive the corporations as less likely to default on the loans compared to other clients. Generally, when customers present less risk to financial institutions, these institutions feel comfortable giving them loans at attractive interest rate. The prime rate is very important since it affects the liquidity of financial markets. A low prime rate of interest increases liquidity, thus making loans more affordable and easy to get..