Both the U.S. prime rate and LIBOR are benchmark interest rates that play a role in what banks charge their customers for loans. However, there are some key differences between these two indexes.
The prime rate is set by each bank and is tied to the U.S. Federal Funds Rate. While the prime rate is variable, it may remain fixed for long periods of time. LIBOR (London Interbank Offered Rate), on the other hand, is an interest rate average based on what leading banks in London say they would charge for a short-term interbank loan. LIBOR changes daily and reacts to current market events.
Another key difference: Prime rate isn’t going anywhere, but LIBOR is now being phased out and will eventually be replaced by SOFR (Secured Overnight Financing Rate) in the U.S.
In the meantime, here’s what you need to know about LIBOR vs. prime rate, how these rates are set, and how they affect the cost of borrowing for consumers and small businesses.
What Is LIBOR?
LIBOR has long been a key benchmark for setting the interest rates charged on adjustable rate loans, mortgages, and corporate debt. One reason for its popularity is that LIBOR makes it easy to calculate rates for upcoming dates. You can get a LIBOR rate for an overnight short-term loan, or you can get a rate for 365 days from now.
However, due to numerous scandals and questions around its validity as a benchmark rate, the U.S. has largely shifted away from using LIBOR. Therefore, within the U.S. market, it’s no longer a case of LIBOR vs. prime rate, since there are very few scenarios where U.S. banks are allowed to use LIBOR. By September 2024, LIBOR will be fully phased out and replaced by SOFR.
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How LIBOR Is Calculated
Every day, the Intercontinental Exchange (ICE) asks roughly 18 global banks at what rate they would charge for a loan in a specific currency and a specific maturity. Those currencies include:
• Euro
• Japanese yen
• Pound sterling
• Swiss franc
• U.S. Dollar
For each currency, the top 25% and the bottom 25% are removed. The remaining rates are averaged. This is done for each maturity, which includes:
• Overnight
• One week
• One month
• Two months
• Three months
• Six months
• One year
In total, there are 35 LIBOR rates published everyday. This is one of the biggest differences between prime rate vs. LIBOR. LIBOR is calculated daily and for multiple currencies, while prime rate is not.
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What LIBOR Is Used For
Lenders, including banks and other financial institutions, have used LIBOR as the benchmark reference for determining interest rates for various debt instruments, including mortgages, corporate loans, government bonds, credit cards, and student loans.
Apart from debt instruments, LIBOR has also been used for other financial products like derivatives, including interest rate swaps or currency swaps.
Though LIBOR will no longer be used for loans in the U.S., it hasn’t fully disappeared yet and will continue to be published until September 2024. Some loans may hang on to it as their benchmark until that time.
What Is Prime Rate?
Prime rate is the rate banks give to their best, most creditworthy corporate customers. However, it’s not the rate most businesses will pay. The rate a bank would quote you for most types of small business loans will simply be based on the prime rate. The prime rate is also used to set rates for credit cards, mortgages, and personal loans.
When comparing business loan rates, you might come across lenders that express the terms of a loan as “prime plus” a certain percentage. The percentage that gets added to prime will depend on the borrower’s credit rating and other factors.
How Prime Rate Is Calculated
The prime rate is tied to the Effective Federal Funds Rate, which is the target for the interest rate banks charge each other for short-term loans. The federal funds rate is established by the Federal Reserve and is based on the economy’s current conditions. Banks generally add 3% to whatever the federal funds rate is. Therefore, if the federal funds rate is 2%, then the prime rate would likely be 5%.
However, there isn’t any single prime rate. Each bank sets its own prime rate that it charges its best customers. But because banks want to remain competitive with one another, many will actually adopt the same or very similar prime rate.
You may have also heard of the WSJ Prime Rate. In a similar fashion to LIBOR, each day the Wall Street Journal asks the largest banks within the U.S. what rate they would charge for a short-term loan to their most qualified customers. When 70% of the banks change, WSJ Prime Rate changes too.
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What Prime Rate Is Used For
Prime rate is used as a benchmark when establishing rates for many loan products. These loan products may include:
• Credit cards
• Small business loans
• Auto loans
• Mortgages
• Personal loans
• Student loans
The prime rate is the starting point for establishing what rate a customer will receive when taking out a loan. However, many things affect what rate a borrower will get. Credit scores, income, debt-to-income ratio, collateral, fixed interest vs. variable interest, and maturity also play key roles in determining how much a person or business will ultimately pay for a loan.
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Differences and Similarities Between LIBOR and Prime Rate
There are some similarities between prime rate and LIBOR, as well as some key differences.
Similarities
• Both rates are used as reference points for lending transactions.
• Both are based on surveys given to large banks asking them at what rate they would lend.
• Both tend to move in the same direction as the federal funds rate.
Differences
• Prime rate is a reactive rate. It only moves after the federal funds rate has changed.
• LIBOR is an anticipatory rate. It moves in anticipation of economic conditions.
• LIBOR is used by 5 different currencies, with 7 different maturities.
• In the U.S., commercial banks may each have their own “prime rate” that they issue to their most qualified and best borrowers.
• LIBOR is published by the ICE.
The most quoted prime rate is published by the Wall Street Journal (WSJ).
| LIBOR | Prime Rate | |
|---|---|---|
| Created in England | ✓ | X |
| Created in the U.S. | X | ✓ |
| Offers 35 different rates | ✓ | X |
| Used for multiple currencies | ✓ | X |
| Each bank has its own rate | X | ✓ |
| It is used as a rate index benchmark | ✓ | ✓ |
| Published by the ICE | ✓ | X |
| Typically moves in the same direction as federal funds rate | ✓ | ✓ |
| Anticipates economic conditions | ✓ | X |
Pros and Cons of LIBOR
| Pros of LIBOR | Cons of LIBOR |
|---|---|
| Based on what the most prominent banks are lending at | Determined by a relatively small group of banks based on their own judgment |
| Forward looking – rates can be given out a year in advance | Numerous scandals have put its validity into question |
Pros and Cons of Prime Rate
| Pros of Prime Rate | Cons of Prime Rate |
|---|---|
| Rate does not change very often | There is no one single prime rate |
| Encourages lenders to charge competitive rates | It will not be the rate you will actually pay for a loan |
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The Takeaway
Both prime rate and LIBOR act as benchmark interest rates. However, LIBOR can be used to calculate future loans because it’s the rate that banks expect they’ll lend at in the coming weeks and months. Prime rate, on the other hand, only represents the going rate.
Prime vs. LIBOR was once a talking point among lenders, but since the end of 2021, LIBOR has been steadily phasing out. While still used in some situations, the U.S. has switched to SOFR.
As a borrower, a benchmark rate, like prime or LIBOR, is only one of many factors that go into determining the interest rate you’ll pay for a loan. If you’re applying for a small business loan, lenders will also look at your credit scores, time in business, annual revenue, and collateral when determining your rate.
If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.
FAQ
How is prime rate and interest rate different?
A bank’s prime rate is the rate it charges its most qualified corporate customers, who are highly unlikely to ever default on a loan. An interest rate is the rate a bank will charge other businesses and consumers for loans.
What does LIBOR stand for?
LIBOR stands for the London Interbank Offered Rate.
Why do U.S. banks use LIBOR?
U.S. banks used LIBOR (London Interbank Offered Rate) as a benchmark because of its global popularity and adaptability in setting the rates for future loans. However, due to its role in numerous scandals, LIBOR has since been replaced with SOFR (Secured Overnight Financing Rate) in the U.S.
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