How The U.S. Prime Rate Works

On Wall Street and throughout the worldwide banking community, the U.S. Prime Rate is understood as the interest rate at which banks lend money to their most creditworthy business customers. Most American banks, credit unions and other lending institutions use the U.S. Prime Rate as an index or base rate for numerous loan products; a margin is added to the Prime Rate depending on how risky the lending institution feels the loan is: the riskier the loan, the higher the margin. However, since the Prime Rate is an index and not a law, business owners and consumers can sometimes find loan products that have an interest rate that's below the U.S. Prime Rate, especially if the loan in question is secured.

The U.S. Prime Rate is determined by adding 300 basis points (3.00 percentage points) to the federal funds target rate (also known as the fed funds target rate.) So if the fed funds target rate is 0.25%, then the U.S. Prime Rate will be 3.25%.

The federal funds target rate is America's most important short-term interest rate, and it is controlled by a group within the U.S. Federal Reserve system called the Federal Open Market Committee (FOMC). The FOMC convenes a monetary policy meeting eight times every year to decide whether to raise, lower or make no changes to the fed funds target rate. The FOMC may also hold an emergency meeting at any time, if economic conditions warrant.

If the FOMC determines that the pace of inflation within the U.S. economy is too high, then the group is more likely to raise the fed funds target rate, so as to bring inflation under control. Conversely, if the FOMC determines that:

• numerous sectors of the U.S. economy are flagging in a significant way, or
  
  
• the U.S. economy is in or is headed for a recession, or
  
  
• a credit crunch in the U.S. banking system is causing serious liquidity issues within the U.S. economy,

then the group is more likely to lower the fed funds target rate, so as to spur economic growth. If the U.S. economy is growing at a moderate pace and inflation is also rising at a moderate rate, then the FOMC is more likely to make no changes to the fed funds target rate.

When it comes to borrowing money, timing is very crucial, so it's important for consumers and business owners to stay informed about what the FOMC is likely to do with the fed funds target rate at the FOMC's next monetary policy meeting. If the U.S. economy is showing clear signs of contraction, then holding off on a fixed-rate loan may be a good idea, since in such an economic environment, short-term interest rates, like the Prime Rate, may be on their way down. On the other hand, if the U.S. economy is growing at a very strong pace and the rate of inflation is relatively high, then borrowing via a fixed-rate loan sooner rather than later may be the smarter option, because in such an economic environment, short-term interest rates may be on their way up.

Click here to view a Flow Chart for the U.S. Prime Rate.