The Relationship between Discount, Prime, and Mortgage Rates
With all the talk of falling interest rates and what that means to U.S. home buyers it’s important to know what’s being spoken about on the nightly news. When the anchor mentions interest rates, is he talking about mortgage interest? He might be. But he might also be referring to the Prime Rate or the Discount Rate. What these three interest rates are, and how they relate to home buyers, is good knowledge to have if you’re planning on a mortgage application any time soon.
Discount Rate
Commercial banks are required by law to maintain a certain amount of liquid assets in the form of cash reserves. These cash reserves are meant to cover loans and withdrawals at times when they exceed revenues. If a bank is short on cash reserves it can borrow money from the Federal Reserve and pay interest just like the average consumer. The interest charged by the Fed to a commercial bank is known as the Discount Rate, which currently stands at .75 percent.
Prime Rate
The Prime Rate, also known as the Reference Rate or Base Lending Rate, is the rate of interest banks charge their best commercial clients. Businesses and institutions are routinely given a credit rating which then affects their individual interest rates; put the Prime Rate is the general yardstick by which commercial rates are determined. Those with the highest credit rating will get the Prime Rate, while those with lesser credit ratings will pay more. As a general rule, banks routinely adjust their Prime Rates at the same time and level.
Mortgage Rate
Obviously, the Mortgage Rate is the rate of interest a bank charges to the average consumer when buying a home. Mortgage rates fluctuate according to a variety of factors, but their movement tends to be more gradual in either direction rather than being prone to big jumps or drops. Mortgage rates are often used as an indicator of the overall health of the nation’s economy.
The relationship between the three types of rates is rather simple. As the Discount rate goes up that cost is passed on to the bank’s borrowers in several ways, one of which is an increase in the Prime and Mortgage rates. An increase in the Prime Rate usually tends to dampen business activity which in turn, puts further pressure on Mortgage rates. Likewise, a reduction in the Discount Rate has the same effect in helping reduce the other two.