Video — The Prime Interest Rate Explained Visually

"Prime has dropped (or raised) 0.X%" Youll see some version of that headline all the time, particularly if youre looking for a mortgage. You may even be considering a loan that is based on "Prime". But what is Prime??

In a nutshell, the prime lending rate is the interest banks charge each other for overnight loans. This rate is based in turn on the interest rate the Federal Reserve charges for money it lends to banks.

Heres an example from the video.

Bank A borrows money from the Federal Reserve, at 1% interest.

Bank B borrows from Bank A at 4% interest.

(Historically Prime has been about 3% above the Federal rate.)

Both Bank A and Bank B recalculate loans "based on Prime" — like Adjustable Rate Mortgages — on that 4% figure.

The short-hand term "above Prime" in the world of mortgages is the margin (or spread) added to the Prime rate. An ARM with 2% margin would be 6% (4% + 2%) in the example above.

Watch our short video to see this explained visually.