What it means
Banks charge their most creditworthy customers a rate called the prime rate, and it acts as the starting point for pricing many other loans. The Wall Street Journal collects the prime rates posted by major banks and publishes a single reference figure that lenders and borrowers can point to in their contracts.
The published rate changes when a clear majority of the surveyed banks change their own rates. In practice this tends to follow changes to the central bank's policy rate, so the prime rate is a quick way to see how monetary policy reaches ordinary borrowers.
A loan is usually written as prime plus a margin, for example prime plus 2%. The margin reflects the borrower's credit risk, the length of the loan and any security offered, while the prime part moves with the market.
This matters to finance teams because it creates interest rate risk. A company with a large floating-rate credit line sees its interest costs rise as soon as the prime rate rises, which can strain cash flow and covenants (conditions set by the lender).
Contracts should name the benchmark clearly, including what happens if it is discontinued or changes in how it is determined. Borrowers can also ask whether the loan has a floor or a cap, which limits how low or high the rate can go.
For a treasurer, the practical task is to measure exposure to the benchmark. Add up all the floating-rate debt linked to prime, multiply by a possible rate move, and compare the extra interest with the cash flow available to pay it.
Many firms then decide how much of the exposure to hedge (protect against) with fixed-rate borrowing or a swap.
In practice
Real-world examples.
Example
A family-run building supplier has a $500,000 revolving credit line at prime plus 1%. When the prime rate rises, the monthly interest bill goes up within one billing cycle, and the owner updates the cash forecast. He also asks the bank whether part of the line could be converted to a fixed rate.
Example
A software startup takes a bank term loan priced at prime plus 2.5% with a floor of 6%. Because the floor sets a minimum rate, the company knows its cost cannot fall below that level even if the prime rate drops sharply. The founder accepts this because the floor allows the bank to offer a lower margin.
Example
A restaurant owner reads his credit card terms and finds the card is priced at prime plus 14%. He sees that changes in the prime rate will pass straight through to the interest on any unpaid balance. He decides to clear the balance from his next good month of takings instead of carrying it.
Formula
Calculation
Loan interest rate = prime rate + margin
Annual interest = loan balance x loan interest rate
Suppose a business has a $200,000 credit line priced at prime plus 1.5%, and for illustration the prime rate is 7.00%. The loan rate is 7.00% + 1.50% = 8.50%, so annual interest on the full balance is 200,000 x 0.085 = $17,000. If prime rises by 0.50 percentage points to 7.50%, the loan rate becomes 9.00% and annual interest is 200,000 x 0.09 = $18,000, an increase of $1,000 a year.Case study
Seen in the real world.
Sandstone Outfitters is an illustrative, fictional retailer with a $1,200,000 credit line priced at prime plus 2%. The line was fully used to fund stock before the holiday season, and the finance manager had budgeted interest on the assumption that the prime rate would stay unchanged.
When the prime rate rose by 1 percentage point, the annual interest cost on the full line increased by 1,200,000 x 0.01 = $12,000. The extra cost arrived just as sales were seasonally weak, and the business came close to breaching a coverage covenant.
The manager then built a simple sensitivity table showing interest cost at prime rates 1 and 2 points higher, and negotiated a cap on the rate. The illustrative lesson is that a floating rate needs a plan for the case where it moves against you. Sandstone now reviews its rate exposure every quarter and reports it to the board alongside cash and stock levels.
Watch out
Common mistakes.
- Assuming the prime rate is the same as the central bank's policy rate, when it is a separate rate that usually sits above the policy rate and moves after it.
- Forgetting to budget for rate rises on floating-rate debt and treating the current interest cost as fixed.
- Ignoring the margin, which can be far more important to the total cost than the prime rate itself.
Questions
People also ask.
Who sets the Wall Street Journal prime rate?
The newspaper publishes it based on a survey of major banks, and it changes when a clear majority of them change their own prime rates. The newspaper does not set it by decree.
Is the prime rate the same for every bank?
No, each bank sets its own prime rate, but they tend to move together, and the published rate reflects the common level.
Can a borrower fix the cost of a prime-based loan?
Often yes, through an interest rate swap or a fixed-rate refinancing, although either option has its own costs. A swap, for instance, can leave the borrower worse off if rates fall.
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