Federal Funds Rate, Federal Discount Rate, Prime Rate - what’s the difference?
With all of the recent news regarding the Fed cutting rate, the Fed’s anticipated rate cut on March 18th, 2008 and some rates going up, it may be difficult to keep track of which rate we are all taking about. The Fed and the economic headlines often use the word “rate” to refer to a variety of interest rates that help steer the economy and provide liquidity to the credit market.
In most cases, whenever one uses the word “rate” and the Fed in a single sentence, they are usually referring to the Federal Funds Rate. A Federal Funds Rate is an interest rate at which banks borrow surplus reserves and is considered to be the shortest short-term interest rate available in the market with maturities ranging from overnight to one-day transactions. It was the federal funds rate that was cut by 75 basis points during an emergency meeting on January 22nd, 2008. The federal funds rate was later lowered by another 50 basis points to reach the current level 3.0%. It is also speculated that during tomorrow’s meeting, the Fed will, once again, lower the federal funds rate by another three-quarters of a percentage point (there are 100 basis points in a full percentage point). If the speculation proves true, the federal funds rate will be the lowest that it has been since December 2004.
On the contrary, the rate that was cut on Sunday, March 16, 2008 is the Federal Discount Rate. A Federal Discount Rate is an interest rate at which eligible depository institutions may borrow funds directly from a Federal Reserve Bank for a short period of time. Depending on the financial condition of the depository institution, they may be able to access either a primary or secondary credit rate. Primary credit may be extended for up to a few weeks, while secondary credit is usually extended on shorter-term basis with a typical term being overnight.
Although the two rates do sound similar, they serve different purposes in the markets. The two rates vary in amounts yet they trend each other closely, with changes in federal funds rate usually being reflected in changes in the discount rates and vice-versa.
Most people are familiar with the Federal funds rate as it is tied to various other financial market instruments and rates. Fluctuations in the funds rate cause similar fluctuations in the other rates, for which the funds rate serves as a base. One of example of these financial rates that uses the federal funds rate as its base is the prime rate. In the US, the prime rate runs approximately 300 basis points above the federal funds rate. Historically, the prime rate was the interest rate, however, that is no longer the case. The prime rate varies little from bank to bank and adjustments to the prime rate are usually done on a larger scale and coincide with changes to the federal funds rate. Prime rate, in itself, serves as a base for determining other interest rates. For example, many credit cards and home equity loans (home equity lines of credit) with variable interest rates, use the prime rate plus a fixed amount (the spread) to determine their variable interest rates. Prime rate is also used as an index to calculate rate changes to adjustable rate mortgages (ARM), some private student loans, and other variable interest rate short-term loans.
Therefore by being able to understand which rate is being impacted by the Fed’s decisions, one can have better visibility whether this change will or will not impact them and their personal financial situation directly.
Tags: discount rate, fed, federal funds rate, funds rate, interest rates, mortgage rates, prime rate, rate cut, short-term interest rates
