What is the difference between the prime rate and the discount rate?
discount rate, aka the Fed Funds Rate, is a short term rate that banks charge each other to lend each other money. The discount rate affects the prime rate which affect home equity lines of credit, credit cards, auto loans and the like.
Home equity lines of credit and credit cards are based on the prime rate. The prime rate can be calculated in the following way... It is the discount rate + 3%= prime rate. For example, the discount rate is currently at 4.75% + 3%= 7.75% prime rate.
In case you are wondering what impact this has on mortgage interest rates, mortgage rates will most often will actually move opposite direction of the discount rate change, due to the dynamics of the financial markets.
I hope this information helps you understand both the discount rate and prime rate.
The initial answer is not exactly correct. It implies that the term "discount rate" and the term "fed funds rate" are synonymous. This is not correct. The discount rate is the rate at which banks may borrow directly from the Federal Reserve. The fed funds rate is the rate at which one bank may borrow another bank's excess Federal Reserve deposits on the open market. The Federal Reserve sets both rates, but the rates are not synonymous.
The discount rate is the rate at which banks can borrowe money from the federal government. The discount window as it is called was recently opened up to Non depository financial institutions (so not JUST banks could borrowe the money.) The reason the government did this was to put liquidity back into the financial markets after the mortgage industry troubles had all but stopped banks and financial companies ability to borrow money.
The Prime rate is a consumer lending rate index, set by the banks, and they base that rate on the federal funds overnight lending rate which is the regulated rate which banks can lend money to each other.
Discount rate = Fed to banks (and financial institutions) lending
Fed Funds Rate = Bank to Bank lending
Prime Rate= Bank to consumer Lending.
It is important to note that the Prime rate is treated as an index, and the loan you get from a bank or credit card may be plus or minus a margin on the index.
You have a credit card that is Prime plus 7.99% which a few months ago was 18.99% Recently the Prime dropped to 5% so your credit card Interest rate dropped to 12.99%
Some low risk loans or Home equity products are prime MINUS a margin. So your HELOC may have been at 7% when Prime was 8% and now it is 4% when the prime is 5%.
The Margin is determined by the credit issuer on a risk vs collateral basis.
To wrap it all up, the cheaper it is for banks and financial institutions to lend each other money the more liquidity we have in the financial markets the more moeny can be lent to consumers which will allow some of the unrated debt from subprime mortgages to obtain market value and begin to be bought and sold, therebuy showing early signs of recovery.
If you are really interested check out credit swaps, and long term fixed income investments and bonds. I hope that helps!