What it means
The prime rate is a benchmark that banks publish. It generally moves up and down in line with the central bank's policy interest rate, usually staying a fixed margin above it.
Banks then price many loans as prime plus or minus a set margin. For a borrower, this means the cost of a variable-rate loan changes whenever the prime rate does.
A business with a credit line priced at prime plus 2% sees its interest cost rise automatically when the prime rate rises. Budgets therefore need to allow for movements in prime.
Not every borrower gets the headline rate. The very best borrowers might pay prime or even a little less, while riskier ones pay prime plus a spread that compensates the bank for the extra risk.
The spread depends on credit history, security offered, the length of the loan and the strength of the business. In the second sense, prime describes high-quality credit.
A prime borrower has a strong credit record, stable income and low debt, and a prime mortgage is one granted to such a borrower. The opposite is subprime, which describes borrowers with weaker credit who are charged higher rates.
Variants exist across countries and markets, and other benchmarks such as interbank or overnight rates now underpin many loans. Check the loan agreement to see which reference rate applies, how often the rate resets and whether there is a floor or cap.
Lenders also use the prime rate to price consumer products, such as credit cards, car loans and home equity lines. A change in prime therefore reaches ordinary households as well as businesses.
Finance teams that sell on credit watch it closely because customers' borrowing costs affect their ability to pay.
In practice
Real-world examples.
Example
A retail chain has a $1,000,000 revolving credit line priced at prime plus 1%. When the prime rate rises, the treasurer updates the cash forecast to include the extra interest. Even a small move in the rate adds up on a large balance.
Example
A small manufacturer with a long trading record negotiates a term loan at prime plus 0.5%. A younger competitor with less history is offered prime plus 3% for the same amount. The difference in margin reflects the lender's view of risk.
Example
A couple with a high credit score and steady income qualifies for a prime mortgage and receives a lower rate than they would have been offered with a patchy credit record. The lender also asks for less documentation and a smaller deposit.
Formula
Calculation
Loan interest rate = Prime rate + Margin.
Assume a prime rate of 7.50%. A company borrows $200,000 on a credit line priced at prime plus 2%, so the rate is 7.50% + 2.00% = 9.50%. Annual interest is $200,000 x 0.095 = $19,000.
If the prime rate rises by half a percentage point to 8.00%, the loan rate becomes 8.00% + 2.00% = 10.00%. Annual interest is now $200,000 x 0.10 = $20,000, which is $1,000 more per year, or about $83 more each month.Case study
Seen in the real world.
Willow Bakery Group is a fictional chain with a $600,000 line of credit priced at prime plus 2.5%. During an illustrative year, the prime rate rose three times, adding a full percentage point to the cost of borrowing.
The finance manager worked out that the extra interest would cost about $6,000 over the year. She decided to fix the rate on part of the loan with a swap and to speed up collection of customer payments, which reduced the amount she needed to draw.
The fictional group ended the year with interest costs under budget. The lesson is that anyone borrowing at a rate linked to prime should model the effect of rate changes before they occur. The rate was then reviewed each quarter alongside the cash forecast.
Watch out
Common mistakes.
- Assuming every borrower pays the prime rate, when most pay prime plus a margin. Ask the lender for the exact margin in writing.
- Forgetting that variable-rate loans move automatically when prime changes. Include a rate rise in your budget as a stress test.
- Confusing prime in the sense of top quality with prime meaning first or primary. Read the context to see which meaning applies.
Questions
People also ask.
Who sets the prime rate?
Each bank sets its own, although in practice banks tend to follow the same level, which tracks the central bank's policy rate. The link to the policy rate is why it moves after central bank decisions.
Is prime the lowest rate available?
Not always, since the best borrowers sometimes negotiate rates below prime, especially in competitive markets. Large companies can borrow in capital markets at rates that do not depend on prime at all.
What is the difference between prime and subprime?
Prime borrowers have strong credit and get lower rates, while subprime borrowers have weaker credit and pay more.
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