Prime Rate vs. Discount Rate: An Overview
Borrowing costs are determined by a variety of factors, which include interest rates. Two common rates are the discount rate and the prime rate. The prime rate is set by the market and based on the federal funds rate. It determines the lending rates that many lenders charge for consumer loan products.
The Federal Reserve Bank sets the discount rate. As a local interest rate, prime can vary from bank to bank.The Fed sets and offers the discount rate to member banks and thrifts that need to borrow money to prevent their reserves from dipping below the legally required minimum. When banks within the U.S. banking system borrow from the central bank, they use the discount rate.
Let's take a closer look at these rates and how they differ.
Key Takeaways
- The discount rate is the rate set by the Fed at which it lends to commercial banks overnight.
- The Federal Reserve Bank sets discount rates and meets regularly to review and potentially change them.
- Banks base consumer loans like mortgages and credit cards on the prime rate, to which they generally add a margin.
- The prime rate is based on the federal funds rate, which is set by the Federal Reserve.
- Mortgages are often based off of the prime rate.
Prime Rate
The prime rate is generally reserved for banks' most qualified customers. These are borrowers who pose the least potential for default risk. Prime rates may not be available to individuals as often as to large corporate entities. Because a bank's best customers have little chance of defaulting, the bank can charge them a rate that is lower than the rate charged to a customer who has a higher probability of defaulting on a loan. The prime rate in the U.S. is 8.5% as of July 27, 2023.
As an index, prime is used as a benchmark for all types of consumer loans. When calculating consumer interest rates, commercial banks add a margin to the prime rate. Products such as home equity lines of credit (HELOCs), mortgages, student loans, and personal loans all have customized interest rates that consider the borrower's creditworthiness.
For example, if the prime rate is 2.75% and the bank adds a margin of 2.25% to a HELOC, then the interest rate for that loan is 5% (2.75% plus 2.25%).
The prime rate has a great impact on consumers whose credit cards, loans, and mortgages have adjustable interest rates. For example, if yourcredit card has a variable annual percentage rate (APR) that changes with the prime rate, your rate fluctuates along with the prime rate. If the prime rate goes up, variable APRs normally rise, too.
The prime rate, which The Wall Street Journal publishes, is a short-term rate, but not as short-term as the discount rate, which typically is an overnight lending rate.
Discount Rate
As noted above, the discount rate is set by the Fed. It has two definitions and uses, depending on the context:
- The discount rate refers to the interest rate that the Federal Reserve offers to commercial banksand other financial institutions.
- The discount raterefers to the interest rate used in discounted cash flow (DCF) analysis to determine the present valueof future cash flows.
The Fed charges the discount rate to other banks and financial institutions for their short-term operating needs. Borrowing entities then use the loaned capital to fund any shortfalls, prevent potential liquidity problems, or, in the worst-case scenario, avert a bank’s failure.
Such loans are servedby the 12 regional branches of the Fed, which grants this special lending facility for a short period. This period, which is 90 days or less, is known as thediscount window. The discount rate is not a market rate, rather it is administered and set by the boards of theFederal Reserve Bankand is approved by itsboard of governors.
Unlike the prime rate, the discount rate is not an index, so banks use the set federal funds rate, without adding a margin, for loans that they make to each other.
The Federal Reserve is responsible for monetary policy, such as adjusting the interest rate, while the government is responsible for fiscal policy, such as adjusting taxes.
Special Considerations
The prime rate and the discount rate significantly affect the consumer loan and banking industries and drive the cost of borrowing. By adjusting interest rates, the Federal Reserve's tight rein on the money supply helps to control inflation and avoid recessions.
For example, the Fed may decide to charge a higher discount rate to discourage banks from borrowing money, which would effectively reduce the amount of money available for consumer and business loans. Or the Fed may lower discount rates to encourage banks to offer more loans.
In general, the Fed will intervene to change rates when it needs to send a cash influx into the economy or to pull some money out of circulation.The Federal Open Market Committee (FOMC) meets at least eight times a year to review and possibly change these rates.
As a rule of thumb, the prime rate adjusts based on how the Fed moves the discount rate. When the discount rate goes up, the prime rate goes up as well. This produces higher mortgage interest rates, which can slow the demand for new loans and cool the housing market.
The opposite is also true. If the Fed lowers the discount rate, the prime rate will come down and mortgage interest rates may dip to more favorable levels, which could boost a slumping housing market. The two rates tend to correlate over time but not as strongly as with the 10-year bond yield, because of its longer maturity.
Key Differences
Although the prime rate and discount rate have some commonalities, they also have some key differences. Businesses and consumers need to understand how these two rates ultimately affect the interest they pay on interbank loans, mortgages, and credit cards.
The following table highlights some of the key differences between the prime rate and the discount rate.
| Key Differences Between Prime and Discount Rates | ||
|---|---|---|
| Prime Rate | Discount Rate | |
| Index? | A benchmark for various other loans. Lenders add a margin to the prime rate to arrive at the rate for consumers. | Not an index, so banks that lend to other institutions use the federal funds rate, without adding a margin. |
| Length of term? | Short-term rate. | Overnight lending rate. |
| Published? | May vary from state to state and the average of banks' prime rates is published in The Wall Street Journal. | Not publicized in a general publication but used in the U.S. banking system as an internal figure. |
What Is the Difference Between the Fed Funds Rate and the Discount Rate?
The fed funds rate is the interest rate at which banks lend to one another. The discount rate is the rate at which the central bank lends to banks as a lender of last resort. The Federal Reserve sets both rates. The fed funds rate will always be lower than the discount rate.
What Does the Prime Rate Mean?
The prime rate is the interest rate that banks charge their corporate customers that have the best credit profile. The federal funds rate is the starting point at which the prime rate is determined and the prime rate is the starting point for which other interest rates are set, such as the rates on mortgages.
Is the Base Rate the Same As the Prime Rate?
The prime rate is considered to be a base rate; it is the base rate in the United States, as most other interest rates are based on the prime rate. These include mortgage rates and personal loan rates.
The Bottom Line
Whether you're an individual who has a mortgage or a bank that borrows from another institution to make up for any shortfalls, you're bound to pay interest. Lenders charge interest when they lend money to their borrowers. Two key rates are the prime rate and the discount rate. The prime rate is what banks charge their most creditworthy borrowers. It also acts as a basis for the interest rates charged to other borrowers. The discount rate, on the other hand, is set by the Fed and is used as a short-term rate (usually overnight) when banks lend to one another.
Correction - July 21, 2022: A previous version of this article mis-specified the discount rate for the fed funds rate.
