Understanding How Lenders Set Rates Through the Prime Rate

The bank loan prime rate is the benchmark interest rate that major U.S. banks publicly post and use as the basis for pricing short-term loans. Many short-term loans have rates that can go up or down over time, like lines of credit and credit cards. By using prime as a base, lenders can adjust what you pay when conditions change while still offering a flexible line of credit you can tap when you need it. A home equity line of credit (HELOC) is one example: a line secured by your home that you draw on over time. Your agreement may describe the rate as prime plus a set amount, so when prime moves, your rate can move with it, depending on your contract and any minimum rate rules. Understanding how prime is set helps you make sense of those changes and compare what you are offered. For more on borrowing against equity, see our HELOC overview.

The Federal Reserve Bank of St. Louis publishes the prime rate as DPRIME: the rate posted by a majority of the top 25 U.S.-chartered commercial banks, ranked by assets in domestic offices. Budget Sidekick uses that St. Louis Fed figure on this site so users across the country have a common comparison.

How banks set their prime rate

Each bank sets its own prime rate. In practice, they still base that posted rate on the federal funds rate. The federal funds rate is the interest rate banks charge each other on overnight loans. It moves with the target range for the federal funds rate set by the Federal Open Market Committee (FOMC)—what news coverage often shortens to "the Fed's rate."

The FOMC sets that target at eight scheduled meetings a year, followed by highly anticipated announcements by the current Fed chair after each meeting. When the target changes, banks typically adjust prime in the same direction. Prime is not the same number as the federal funds rate; in the U.S. it has traditionally been quoted several percentage points above the funds rate, with a relatively stable spread.