Definition of Prime Rate
What is the prime rate? The prime rate, or prime lending rate, is the best interest financial institutions offer the most creditworthy customers. Most banks take the national prime rate and add a 3 percent margin. You’ve probably seen or heard advertisements for “Prime + X percent” loans or credit cards. It works much the same for business loans.
Prime borrowers – established business owners with good credit scores – usually qualify for the prime rate although other variables can impact the loan decision.
Banks and other lenders use the national prime rate as a starting point for loans, credit cards, business mortgages, business loans, auto loans and home mortgages. They typically add a prime rate margin to the national prime rate relative to the amount of risk. The higher the risk, the higher the margin. Prime borrowers – those with the best credit records – get the lower rates.
The prime rate is calculated using another metric: the federal funds rate. That’s the interest rate commercial banks charge each other for overnight lending, and it is set by the Federal Open Market Committee (FOMC), which meets regularly throughout the year. That’s the rate the Federal Reserve Board uses to loan money to banks.
The prime rate is not really determined by any government body. The banks set the prime rate. However, they use the federal funds rate as a starting point. While banks can make independent decisions and set their own rates, most add a standard percentage to the current federal funds rate to calculate prime.
What Does the Prime Rate Mean?
The Federal Reserve lowers or raises the federal fund rate with changes in the economy. When there’s a change, most banks adjust their prime lending rates within a short time span.
When the federal fund rate goes up, it leads to a prime rate increase. That means higher rates for loans and higher costs for consumer and business borrowers. Even small upticks in rates can impact loan amounts. While fixed-rate loans will not be affected, variable rate loans are sensitive to Fed rate hikes and can change quickly.
Fixed rates have locked-in rates for the term of the loan. That means no changes during the term. As such, the prime rate only impacts the loan when it’s originated. For variable rate loans, such as variable lines of credit, the rate can rise immediately. That means a higher cost over the life of the loan and an almost immediate increase in the monthly payments you need to make.
For example, let’s say you have a variable small business loan of $100,000 with a 5-year term at 10 percent. A half-point increase in the loan rate can mean an additional $3,300+ out of your pocket over the life of the loan.
If you use a business credit card, you will also likely see an increase in rates. If you tend to carry a balance, the amounts that are not paid off are going to get more expensive.
If you have business savings, there can be a positive effect. Although deposit and savings rates do not increase at the same pace as the prime rate, savings rates often increase. When it does occur, there is typically a lag time of 2-6 months after a prime rate increase.
Why Do Prime Rates Change?
When prime rates are low, it spurs borrowing and stimulates the economy. The opposite is true as well. Higher prime rates make it more difficult for businesses – especially small businesses – to afford the cost of loans.
The Fed tends to lower interest rates when unemployment is high, or the economy is sluggish. That reduces the prime rate banks set and encourages lending and investment. When the economy is going strong and inflation is expected to rise, the federal fund rate is raised. Prime goes up as well. This theory is that the increased rate helps to keep prices and spending under control.
What Is Prime Rate?
You can check on the current bank prime loan rates on the Federal Reserve’s website. In the past few years, the prime rate has gone up from 4.25 percent to 5.50 percent (where it stands today). When inflation peaked in 1980, the prime lending rate charged by some banks reached as high as 21.5 percent. Remember, that is what banks charged for their best customers. For businesses with credit issues or less time in business, rates went even higher. It is almost hard to imagine by today’s standards.
Will Prime Rate Increase?
The Federal Reserve Chairman Jerome Powell signaled in March that they do not expect to hike rates in 2019.
“Given the overall favorable conditions in our economy, my colleagues and I will be patient in assessing what if any changes in the stance of policy may be needed,” Powell said in a news conference.
So, will the prime rate increase? While the current thinking is that it will not go up anytime soon, things can change quickly. This stance is in stark contrast from December when the Federal Reserve said it was anticipating 2 to 3 rate hikes in 2019.
“We see no need to rush to judgment,” Chairman Powell said. “It may be some time before the outlook for jobs and inflation calls clearly for a change in policy.”
Future lending rates are one of the key variables you want to consider when looking at business loans. If you suspect rates will rise, you may want to lock in rates as soon as you can.
The Lower the Risk, the Better Deal You Will Get
Any time a business takes out a loan, the lender runs the risk that the borrower will not pay it back. To compensate for this risk, lenders charge interest. The better credit risk you are, the smaller interest you will likely be charged. When taking out a loan for your business, there are a variety of factors that can impact the rate you get. While you always want the lowest rate possible, you may not qualify for prime rate finance rates if lenders have concerns about your credit score or credit history. They will also examine your length of time in business.
Depending on the business you are in, rates may also vary. If your industry has a higher than average default rate, you may be negatively impacted no matter how strong your business performs. Demonstrating you have a solid business plan for future growth can help.
The lower the risk for the lender, the better deal you are likely to get.