What is the Prime Lending Rate? Meaning Explained With Examples

Another name for the prime rate is the prime lending rate. It is an interest rate bank charges on loans of customers with the highest credit rating. The bank charges the prime rate from the most creditworthy customers. Most of these are corporate customers. These customers borrow from commercial banks to finance the operation of their businesses. Commercial banks charge such a rate, which is the most appropriate for their customers. The bank charges an average rate that is less than the interest rate. This average rate is known as the prime rate. The bank sets the prime rate to the most reliable customers of the bank.

Did you know?

The highest record-breaking prime lending rate stood at 21.5% on 19th December 1980.

Meaning of Prime Rate

In simple language, the prime rate is also an interest rate. But, commercial banks charge prime rates to the most reliable customers. At the same time, the interest rate is a charge to all the general customers. On the other hand, the bank charges interest rates to customers prone to default. 

India has witnessed many reforms in its financial sector in the last few years. Commercial banks were empowered to determine interest rates on their own during these reforms. The guidelines set by the Reserve Bank of India allow the other commercial banks to determine the rates. RBI introduced the Prime Lending Rate or Benchmark Prime Lending Rate (BPLR). The concept was introduced to help the banks keep the interest rates at a similar or competitive rate known as the base rate.

What Does Base Rate Mean?

The base rate is the minimum interest rate below which no Indian bank can lend to the customers. The Reserve Bank of India sets the base rate. As per the guidelines of RBI, no bank can determine the interest rate below the base rate. RBI introduced a base rate with effect from July 1, 2010. Commercial banks in India offer a standard lending rate. This standard lending rate is the base rate. The main aim of introducing the base rate is to ensure the benefits of lower interest rates to borrowers. The introduction of the base rate has brought transparency to the lending of money.

Also Read: Who is DSA Loan Agent & DSA Loan Agent Registration Process

How to Determine Base Rate?

The RBI determines the base rate. It determines the base rate to make the uniform interest rate across the country, which is also a standard rate across all the nationalized banks and private banks. 

Different factors help to calculate the base rate. These factors include:

• Costs of Deposits
• Administrative costs
• Profits of banks in the previous financial year
• Other costs

Costs of deposits have maximum weights while considering the base rate. Banks can determine the cost of the deposit while determining the base rate.

Factors to Determine the Base Rate

As mentioned earlier, all banks can determine the base per the guidelines of RBI. Base rates include all the essential elements of prime rates, which are the same for all customers. However, the base rate may differ for different banks based on some factors. These factors are

• Determination of interest rate by the bank
• Operation cost
• Minimum return rate
• Cash reserve ratio

The base rate may differ for different banks due to the abovementioned factors. 

Important Features of Prime Rate 

Prime rates mainly affect the various loans of the bank. Some of the essential features of prime rates are as follows:

• When the prime rate goes high, the cost of operation of small businesses, car loans, and mortgages also increases.
• The prime rate affects the variable interest rate due to changes in the rate.
• The prime rate is only for the most reliable customers, less prone to default on the interest rate payment.
• Even if the prime lending rate is unavailable to individual customers, it may be available to corporations and other large businesses.
• Another essential feature of the prime rate is that if the prime rate is set at a certain percentage, the lender may still choose to offer below that rate to qualified customers.

Changes in Prime Rate Over Time

Prime rate changes over time-based on the changes in the federal funds rate. Some of the current prime rates that changed have been mentioned below.

Qualification for Prime Rate

Those borrowers who are the most creditworthy are qualified for the prime rate since the prime interest rate is the lowest rate the bank charges to customers with good credit scores. When the banks find that a particular customer will not default while paying the interest rate.

Those who are individual customers are qualified for prime rates based on prime plus based on the individual creditworthiness and the representation of the risk.

Prime Rate and Overnight Rate

The prime lending rate is mainly dependent on the cost. On the other hand, the bank charges an overnight rate to another bank when the former lends money to the latter. The banks charge prime or overnight rates to individuals and institutions that are the most creditworthy customers.

The credit of the commercial bank decreases when the overnight rate increases. The overnight rate can help to determine the status of the economy. When the reliability of the most reliable borrowers decreases, the economy also deteriorates. In the same way, when the prime rate increases, large corporations or entities face financial challenges. When such corporations face financial difficulties, they default on the interest rate payment. The default leads to low credit scores and the prime rate decreases.

Also Read: What is Loan Against Securities?

Loan Interest Rate vs Prime Rate

There is a belief that housing loans rates are associated with prime lending rates. But there is a minimal relationship between the two. Home equity lines of credit and credit cards are related to the prime rate. But loan rates are connected to the bond market and other market factors.

When a lender creates a mortgage, it turns into Mortgage-Backed Securities (MBS). Then it is sold in the bond market. Because the same investors purchase MBS as 10 years of treasury bonds. But 10-year treasury bonds and MBS are different.

Conclusion

The prime lending rate helps a cordial relationship helps to maintain a cordial relationship between commercial banks and customers. The base rate or prime rates in India is the standard rate followed by almost all the banks including nationalized and private banks. 

It makes the process of borrowing and lending money easy and convenient. Even the prime rate also helps to determine the conditions of the economy. The economic condition is determined based on the increase and decrease of the prime rate. However, large business institutions can affect the prime rate. The prime rates decrease when a large business corporation makes itself the most creditworthy customer because the customers pay the debt without default.

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