Prime Rate
Prime Rate
The interest rate commercial banks charge their most creditworthy corporate customers, serving as a benchmark for consumer and business loan rates including credit cards, mortgages, home equity lines of credit, and auto loans. Typically set approximately 3% above the federal funds rate. Individual banks set their own prime rates, though most major banks use the same rate published as the Wall Street Journal Prime Rate.
When the Federal Reserve raises the federal funds rate by 0.25%, most banks raise their prime rate by the same amount within days. A client with a credit card charging "prime plus 12%" would see their rate increase from 15.5% to 15.75%, directly affecting their borrowing costs.
Students often mistakenly believe the prime rate is set directly by the Federal Reserve. In reality, individual banks set their own prime rates based on the federal funds rate. The Fed influences the prime rate indirectly through monetary policy, but does not mandate it.
How This Is Tested
- Understanding the relationship between the federal funds rate and the prime rate (typically 3% spread)
- Identifying who sets the prime rate (individual banks, not the Federal Reserve)
- Recognizing which types of loans are benchmarked to prime rate (credit cards, HELOCs, some adjustable-rate mortgages)
- Calculating borrowing costs when rates are expressed as "prime plus" a spread
- Understanding how changes in Fed monetary policy indirectly affect prime rate and client borrowing costs
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Typical spread above federal funds rate | Approximately 3% | Historical convention, not a regulatory requirement |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Jennifer, a financial advisor, has a client who is concerned about rising interest rates. The client has a $75,000 home equity line of credit (HELOC) with an interest rate of prime plus 1.5%, currently at 9.0%. The Federal Reserve has just announced a 0.50% increase in the federal funds rate. What should Jennifer explain to her client about the likely impact on her HELOC payment?
B is correct. When the Fed raises the federal funds rate by 0.50%, banks typically raise their prime rate by a similar amount within days. If prime increases from 7.5% to 8.0%, the client's HELOC rate (prime plus 1.5%) would increase from 9.0% to 9.5%, directly increasing her borrowing costs.
A is incorrect because the prime rate is not fixed by regulation. It adjusts based on market conditions and Fed policy, with most banks following the Wall Street Journal Prime Rate. C misunderstands the "prime plus" structure: the 1.5% spread stays constant, so only the 0.50% prime rate increase affects the total. The 3% is the typical spread between federal funds rate and prime, not an additional charge. D reverses the relationship: higher federal funds rates lead to higher prime rates, not lower.
The Series 65 exam tests your ability to advise clients on how Federal Reserve monetary policy actions affect their real-world borrowing costs. Understanding the prime rate mechanism is essential for financial planning, especially for clients with variable-rate debt like HELOCs, credit cards, or adjustable-rate mortgages that adjust based on prime rate movements.
Who determines the prime rate charged by commercial banks?
C is correct. Individual commercial banks set their own prime rates based on market conditions and the federal funds rate. While most major banks use the same rate (the Wall Street Journal Prime Rate, which is published when at least 70% of the largest banks change their rates), each bank technically makes its own decision.
A is incorrect because the Federal Reserve does not set the prime rate directly. The Fed sets the federal funds rate target and influences prime indirectly through monetary policy, but banks determine their own prime rates. B is incorrect because the Treasury Department has no role in setting interest rates for bank lending. The Treasury borrows money by issuing securities but does not set private lending rates. D is incorrect because the SEC regulates securities markets and investment advisers, not bank lending rates.
The Series 65 exam frequently tests the distinction between rates controlled by the Federal Reserve (federal funds rate, discount rate) and rates set by private institutions (prime rate). This knowledge is critical for explaining to clients how Fed policy changes will likely affect their borrowing costs, even though the connection is indirect rather than direct.
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Access Free BetaA client has a $200,000 outstanding balance on a business line of credit with an interest rate of prime plus 2.75%. If the current prime rate is 7.50%, what is the client's annual interest cost on this loan?
B is correct. Calculate the total interest rate first: Prime rate (7.50%) + Spread (2.75%) = 10.25% total rate. Then calculate annual interest: $200,000 × 0.1025 = $20,500.
A ($15,000) incorrectly uses only the prime rate without adding the spread: $200,000 × 0.075 = $15,000. This is a common error when students forget about the "plus" component. C ($22,500) appears to miscalculate by adding the rates as decimals instead of percentages. D ($27,500) incorrectly treats the prime rate and spread as separate charges rather than adding them together to find the total rate, possibly calculating ($200,000 × 0.075) + ($200,000 × 0.1025).
Calculation questions involving prime-based lending rates are common on the Series 65 exam. Investment advisors must be able to calculate actual borrowing costs to help clients evaluate whether to pay down debt, refinance, or maintain their current loan structure as part of comprehensive financial planning.
All of the following statements about the prime rate are accurate EXCEPT
C is correct (the EXCEPT answer). The prime rate is NOT set by the Federal Reserve. Individual commercial banks set their own prime rates based on market conditions and the federal funds rate. This is one of the most commonly tested misconceptions on the Series 65 exam.
A is accurate: the prime rate serves as a benchmark or base rate for a wide variety of consumer loans (credit cards, auto loans) and business loans (lines of credit, commercial loans). B is accurate: by convention, the prime rate is typically set approximately 3% above the federal funds rate target, though this spread can vary slightly during periods of market stress. D is accurate: variable-rate credit cards typically charge "prime plus" a spread (e.g., prime plus 12%), and home equity lines of credit commonly use prime as the base rate.
The Series 65 exam tests your ability to distinguish between interest rates controlled by the Federal Reserve (federal funds rate, discount rate) and market-determined rates set by private institutions (prime rate). Understanding this distinction is critical when explaining to clients why their borrowing costs change when the Fed adjusts monetary policy.
The Federal Reserve announces a 0.75% increase in the federal funds rate target as part of its efforts to combat inflation. Which of the following statements about the likely effects on the prime rate are accurate?
1. Most major banks will lower their prime rate within a few days
2. The prime rate will likely increase by approximately 0.75%
3. Borrowers with loans priced at "prime plus" a spread will see their rates increase
4. The spread between the federal funds rate and prime rate will remain approximately 3%
C is correct. Statements 2, 3, and 4 are accurate.
Statement 1 is FALSE: When the federal funds rate increases, banks raise their prime rate, not lower it. The relationship is direct and positive: higher federal funds rate leads to higher prime rate.
Statement 2 is TRUE: Banks typically adjust their prime rate to maintain the approximate 3% spread above the federal funds rate. A 0.75% increase in the fed funds rate typically results in a matching 0.75% increase in prime rate within days.
Statement 3 is TRUE: Any loan with an interest rate tied to prime (expressed as "prime plus" a spread) will see its total rate increase when prime increases. For example, a credit card at "prime plus 10%" would increase from 17.5% to 18.25% if prime rises from 7.5% to 8.25%.
Statement 4 is TRUE: The conventional spread between the federal funds rate and prime rate is approximately 3%. When the fed funds rate increases, banks typically raise prime by the same amount to maintain this spread, though the exact spread can vary during unusual market conditions.
The Series 65 exam tests your understanding of how Federal Reserve monetary policy actions cascade through the interest rate system to affect client borrowing costs. Investment advisors must recognize these relationships to provide comprehensive financial planning advice, especially during periods of changing Fed policy when clients face rising costs on variable-rate debt.
💡 Memory Aid
Think "Prime = Best Customers Pay, Plus 3": Banks charge their PRIME (best) customers the prime rate. Everyone else pays prime PLUS a spread based on creditworthiness. The prime rate sits about 3% above the federal funds rate. Key distinction: Fed sets fed funds, Banks set prime (but they move together). When Fed raises rates to fight inflation, prime follows up like a loyal puppy.
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Where This Appears on the Exam
This term is tested in the following Series 65 exam topics: