What Does "Prime Rate" Mean?

Most of the time, when you see the term "prime rate," it's referring to the interest rate that large banks charge on short-term loans to their best customers. The prime rate plays an important role in real estate, because interest rates for many loans, such as adjustable-rate mortgages and home equity lines of credit, are tied directly to the prime rate.


The majority of major banks charge the same prime rate at the same time. The "Wall Street Journal" regularly surveys the 30 largest U.S. banks and publishes the consensus rate. When three-quarters of the banks go to a new rate, the "Journal" changes its published rate.


The interest charged on many variable-rate loans is indexed to the prime rate printed in the "Wall Street Journal," as is known as the "WSJ Prime Rate." That means that the interest rates on those loans rise and fall in tandem with the prime rate. For example, if a loan agreement states that the interest rate will be the WSJ Prime Rate plus 4 points, adjusted once a year, if the WSJ Prime Rate is 3.25 percent, the loan's initial interest rate will be 7.25 percent. After one year, that loan resets. If the prime rate has fallen to 2.75 percent, the loan's rate will be 6.75 percent. If the prime rate has shot up to 5.5 percent, the new rate will be 9.5 percent.


The rate has fluctuated greatly over the years. It hit an all-time high of 21.5 percent in December 1980, and was above 10 percent for most of the 1980s. It dropped below 10 percent in January 1991 and stayed there for the next two decades, reaching 3.25 percent by late 2008. The prime rate doesn't change on any regular schedule. It can remain the same for weeks or months at a time--it stayed at 4 percent from June 2003 to July 2004--or it can change rapidly--it changed five times in November 1981.


In the words of Bankrate.com, the prime rate moves "in lock step" with the actions of the Federal Reserve Board. The board sets the Federal Funds Rate, which is essentially the rate that banks charge each other for short-term loans. This rate has a domino effect on almost all other rates. Since at least 2000, the WSJ Prime Rate has consistently been 3 percentage points above the Federal Funds Rate.


Occasionally, the term "prime rate" will be used to describe the actual interest rate on a mortgage. In this case, "prime" refers not to the rate, but to the borrower. People who meet all the traditional mortgage underwriting criteria--people with good credit, steady income, low debt and verifiable assets--are called "prime" borrowers. Those who don't meet the standards are called "subprime" borrowers. Prime borrowers have access to loans on the best terms with the best rates. In this context, "prime rate" refers to a rate available only to prime borrowers.