What is the Average Prime Rate?
The average prime rate is the benchmark interest rate that commercial banks use to set rates for their most creditworthy customers. It serves as a foundation for many consumer and business loan rates.
Formula
The average prime rate is calculated using a simple formula:
[\text{Average Prime Rate} = \text{Federal Funds Target Rate} + 3%]
Banks typically add 3 percentage points to the Federal Funds Target Rate to establish their prime lending rate.
How It Works
The Federal Reserve sets the Federal Funds Target Rate, which is the interest rate at which banks lend money to each other overnight. Commercial banks then add a 3% margin to this rate to determine their prime rate for lending to customers.
Example Calculation
If the Federal Funds Target Rate is 2.0%:
Average Prime Rate = 2.0% + 3% = 5.0%
This 5.0% rate would then be used as the base rate for various consumer loans and credit products.
Impact on Borrowing
The prime rate directly affects:
- Credit card interest rates - Often set as prime plus a margin
- Home equity lines of credit (HELOCs) - Typically tied to the prime rate
- Auto loans - May be influenced by prime rate changes
- Small business loans - Often priced relative to the prime rate
Historical Context
The 3% spread between the Federal Funds Rate and the prime rate has been a consistent banking industry standard for decades. This margin compensates banks for the additional risk and costs of lending to customers compared to interbank lending.