Banking Interest Rates

The U.S. Prime Rate, also known as the Prime Lending Rate, is the base rate for consumer market lending in the United States. Invariably 3 percentage points above the fed funds target rate, the U.S. Prime Rate determines the interest rates at which loan products such as mortgages ans business loans will be offered to consumers. Like the Fed, Prime Rate is a reflection of what is offered to a lending institution's best, most qualified customers.

Most lending institutions in America use the U.S. Prime Rate as an base rate for loans; a percentage-point margin is added to the Prime Rate for loans that lending institutions consider to be risky. That is why "sub-prime" loans hold a higher interest rate than those prime loans usually awarded to customers with stellar credit histories. Banks and credit unions can also offer loans with interest rates below the Prime Rate at their own discretion, since the Prime Rate is not a law.

For more on the Prime Rate, visit www.wsjprimerate.us

The U.S. Federal Funds Target Rate, also known as the Federal Funds Rate or the Fed, is the interest rate at which banks lend short-term loan products backed by funds in the Federal Reserve to other banks. The Fed funds target rate is used to regulate the supply of money in the U.S. economy by acting as a representation of what the market norm should be for well-qualified borrowers, like banks themselves. The Fed Funds Target Rate is decided at Federal Open Market Committee (FOMC) meetings by the governing board. Based on the economic climate in the U.S. the FOMC members adjust the Fed or let is stand.

The Federal Reserve cannot actually mandate a set rate of interest because so it is actually a target rate that represents a fixed index rate by which U.S. monetary policies should be derived. However, this target rate is achieved through open market operations because the Federal Reserve is like the banks' bank. Therefore, setting a higher or lower discount rates the Federal Bank either discourages or encourages banks from requisitioning funds from the Federal Bank. The interest rate that the Fed charges banks is the average rate of what the banks will charge each other, making the flow of funds as fair and balanced as possible.

For more on the Fed Funds Target Rate, visit www.wsjprimerate.us

The London Interbank Offered Rates (LIBOR) can be described as the wholesale cost of money in the London interbank money market. Though the LIBOR rates are fixed in the United Kingdom, American consumers need to understand how LIBOR works, since LIBOR is used as an index in the pricing of many types of consumer loans in the United States.

How LIBOR Works

LIBOR is the average interest rate charged when banks in the London interbank money market borrow unsecured funds from each other. There are many different LIBOR rates (maturities range from overnight to 12 months) for numerous currencies, including Eurodollars. A Eurodollar is an American dollar on deposit in any bank outside the United States, and is therefore not subject to regulation by the U.S. Federal Reserve.

LIBOR rates are fixed every UK business day by the British Bankers' Association (BBA), a not-for-profit trade association.

Just before 11:00 a.m. GMT, the BBA polls a specific panel of highly reputable, high-volume banks which participate in the London wholesale money market. The BBA finds out the rate at which each bank on the panel could borrow Eurodollars from other banks, for specific maturities. The BBA figures out the central tendency -- the interquartile mean -- for each maturity, then publishes these rates at about 11:30 a.m. GMT.

Three American banks are included in the panel surveyed by the BBA for Eurodollar fixing: Citibank, Bank of America and JP Morgan Chase. There are also 13 non-U.S. banks surveyed for Eurodollar fixing in London, bringing the total Eurodollar panel count to 16. To get the interquartile mean for each maturity, the BBA starts with the 16 rates, discards the four lowest and four highest rates, then determines the average of the remaining 8 rates.

Back in the mid-1980's, the international banking system adopted LIBOR as a much needed benchmark for short-term, interbank loans. The LIBOR rates are now globally recognized indexes used for pricing many types of consumer and corporate loans, debt instruments and debt securities across the globe. For example, LIBOR is used as a benchmark for the vast majority of interest-only loans in The United States.

Copyright © 2009 Steve "AmCy" Brown, www.FedPrimeRate.com