What is the Prime Rate?

Prime Rate Definition

Prime rate or prime lending refers to the lowest commercial interest rate charged by a banks at a particular time. It is also used as the reference rate for the bank for all of it’s other rates.

Generally when speaking about the prime rate, it is used as the basis of calculation for a variable rate mortgage. 

At one time, the term “prime rate “indicated the rate of interest at which banks lent to favored customers, i.e., those with high credibility or wealth, though this is no longer always the case. Variable interest rates may be expressed as a percentage above or below prime rate, as well as the rates used for personal and home equity lines of credit. Lending products that are based on the prime rate are now usually available to all borrowers that qualify for them, not just those with considerable wealth or banking history with the lender.

Banks can set their own prime rate for their customers, but typically the prime rate among banks is identical. The prime rate is affected by the overnight rate set by banks when loaning funds on a daily basis to other banks, and by the target overnight rate, used by the Bank of Canada as a means of controlling monetary policy. In most cases, the prime lending rate will change in the same direction and by the same amount as any change to the overnight rate. For instance, if the Bank of Canada announces a decrease to the overnight lending rate of one quarter of 1%, then you can expect the prime rate to drop by one quarter of 1%.

Prime Rate and Mortgages

Interest rates used for the variable and adjustable rate mortgages as well as home equity lines of credit (HELOC’s), are based on the prime rate. For instance, variable rate mortgages may be offered as "prime plus", loans with the variable mortgage rate set at a percentage above the prime rate. The prime rate is also used as an index in calculating rate changes for these mortgage products.

Example

Mr. McGillicuddy has a variable rate loan that will fluctuate with the mortgage holder’s prime rate. The mortgage will charge an interest rate of 1% above the prime rate. The prime rate when the loan is taken is 2.75%. Mr. McGillicuddy will initially pay a rate of 3.75% on the mortgage. If the prime rate increases to 3%, the borrower’s mortgage rate to 4%.

Fixed mortgages rates, however, do not fluctuate with changes to the prime rate as they are influenced by yields in the bond market.

At First Foundation, we understand the benefits and risks of choosing a mortgage product that is based on the prime rate and we can assist you in determining if it’s the right fit for your lifestyle and financial goals.

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Last updated Apr 23, 2014