Prime rate

Prime rate is a term applied in many countries to a reference interest rate used by banks. The term originally indicated the rate at which banks lent to their most favoured customers, though this is no longer always the case. Some variable interest rates may be expressed as a percentage above or below prime rate.


Use in different banking systems

USA and Canada

Historically, in North American banking, the prime rate was the interest rate charged by lenders to borrowers whom they considered most creditworthy, although this is no longer the case. The prime rate varies little among banks, and adjustments are generally made by banks at the same time, although this does not happen with great frequency. The prime rate is currently 8.25% in the United States (as of June 30, 2006), according to data published by the Federal Reserve Bank. Canadian prime rate is currently 6.25% by Bank of Canada (as of Jul 11, 2007). The prime rate is one of the ways the central bank, such as the Federal Reserve, controls the spending habits of consumers.


Overview

In general, the prime rate runs approximately 300 basis points (or 3 percent) above the federal funds rate, the interest rate that banks charge to each other for overnight loans made to fulfill reserve funding requirements. (The Federal funds rate plus a much smaller increment is frequently used for lending to the most creditworthy borrowers today, as is LIBOR, the London Interbank Offered Rate.) The Federal Open Market Committee (FOMC) meets eight times per year wherein they set a target for the federal funds rate. Other rates, including the Prime Rate, derive from this base rate.

The most commonly recognized prime rate index is the Wall Street Journal Prime Rate (WSJ Prime Rate), published in the Wall Street Journal. Unlike other indexed rates, the prime rate does not change on a regular basis; rather, it changes whenever banks need to alter the rates at which borrowers obtain funds. The WSJ defines the prime rate as "The base rate on corporate loans posted by at least 75% of the nation's 30 largest banks." It has been speculated though that this is no longer the real definition, (and that the prime rate is simply the fed funds target rate + 3) because most corporate loans are indexed to LIBOR.[citation needed]

When 23 out of 30 of the United States' largest banks change their prime rate, the WSJ prints a composite prime rate change.

Uses

The Prime Rate is used often as a index in calculating rate changes to adjustable rate mortgages(ARM) and other variable rate short term loans. It is used in the calculation of some private student loans. Many credit cards with variable interest rates have their rate specified as the prime rate(index) plus a fixed value commonly called the spread

Ownership equity

At the start of a business, owners put some funding into the business to finance assets. Businesses can be considered for accounting purposes to be sums of liabilities and assets; this is the accounting equation. After liabilities have been accounted for, the positive remainder is deemed the owner's interest in the business. Thus, in accounting terms, ownership equity is the remaining interest in all assets after all liabilities are paid. If valuations placed on assets do not exceed liabilities, negative equity exists.

This definition is helpful when a business is not paying its bills and gets liquidated, wound up, put into receivership or bankruptcy. Then, a series of creditors, ranked in priority sequence, have the first claim on the proceeds (e.g. asset sales), and ownership equity is the last or residual claim against assets, paid only after all other creditors are paid. In such a case, creditors may not get enough money to pay their bills, and nothing is left over to reimburse owners' equity. Thus owners' equity is reduced to zero. Ownership equity is also known as risk capital, liable capital and equity.

When the owners are shareholders, the interest can be called shareholders' equity; the accounting remains the same, although shareholders may allow different priority ranking among themselves by the use of share classes, and options. This complicates both analysis for stock valuation, and accounting.

Advantages

Refinancing may be undertaken to reduce interest costs (by refinancing at a lower rate), to pay off other debts, to reduce one's periodic payment obligations (sometimes by taking a longer-term loan), to reduce risk (such as by refinancing from a variable-rate to a fixed-rate loan), and/or to liquidate some or all of the equity that has accumulated in real property during the tenure of ownership.

In essence, refinancing a mortgage or other type of loan can lower the monthly payments owed on the loan either by changing the loan to a lower interest rate, or by extending the period of loan, so as to spread the re-payment out over a long period of time. The money saved can be used to pay down the principal of the loan, thus further reducing payments. Alternately, refinancing can be used to transform available equity in one's house into ready cash, available for other purposes or expenses.

Another use of refinancing is to reduce the risk associated with an existing loan. Interest rates on adjustable-rate loans and mortgages shift up and down based on the movements of the various prime rates used to calculate them. By refinancing an adjustable-rate mortgage into a fixed-rate one, the risk of interest rates increasing dramatically is removed, thus ensuring a steady interest rate over time.

Refinancing a loan or a series of debts can assist in paying off high-interest debt such as credit card debt, with lower-interest debt such as that of a fixed-rate home mortgage. The net savings between the two interest rates can then be applied either towards further paying down the debt, or other purposes. In addition, non-tax deductible debt, such as credit card or car loan debt, can be transformed into tax-deductible debt such as home mortgage debt, potentially lowering one's taxes or shifting one into a more advantageous tax bracket. This type of arrangement is often associated with a Cash-Out Refinance.