prime

What It Is

In the finance world, prime is short for prime rate, which is the interest rate commercial banks charge their most creditworthy customers, which are usually corporations.

How It Works

Anyone who has borrowed money knows that different banks charge different interest rates. So when people refer to the prime rate, they are usually referring to the average prime rate among banks. The Wall Street Journal is the most common source for this statistic. It calculates the average prime rate by surveying the 30 largest banks in the U.S. Below is a sample graph of the historical average prime rate published by the Federal Reserve, which surveys 25 banks across the nation.

In general, the rate is the same among nearly all the surveyed banks, and they tend to change their rates at the same time. When 75% of these banks (23 banks) change their rates, The Wall Street Journal changes its average.

Why It Matters

Prime is one of the most widely used market indicators, albeit a lagging one, and it is a major benchmark for mortgage and credit card rates. It is often the basis for adjustable-rate loans. For example, if a bank is offering a home equity loan at “prime plus 5” and its prime rate is 6%, then the bank is essentially offering borrowers an 11% loan (6% + 5%) whose interest rate will fluctuate with the prime rate. It is important to remember that not everyone qualifies for prime -- this rate is only for customers least likely to default.

Source: Investing Answers