One of the biggest challenges when taking out a loan is the high interest rates charged by lending institutions. These interest rates can significantly increase the money you need to pay back and put an unfortunate dent in your finances.
However, if lenders view you as a trustworthy client with a high credit score and good financial profile, you can avail the loan at a better interest rate, known as the prime lending rate.
This article explores the prime lending rate meaning, the factors affecting it, and how it can affect the loans you borrow.
What is the Prime Lending Rate?
The Prime Lending Rate (PLR) is the interest rate lending institutions use as a base to determine the interest rate for their loan products.
You can define prime interest rate as the lowest rate at which financial institutions lend money. It is used as a reference point to set interest rates for various variable-rate financial products such as mortgages and personal loans.
Changes in key policy rates by the Reserve Bank of India (RBI) influence the prime lending rate.
Commercial financial institutions offer prime lending rates to their most creditworthy consumers on short-term loan products, including variable-rate personal and business loans.
Consumers who benefit from the prime lending rate include people who have:
1. High credit score,
2. Strong financial profile, and
3. Low default risk.
Conversely, consumers with a low credit score or higher perceived risk may be charged a higher interest rate by lenders.
Key Factors Affecting Prime Lending Rate in India
Prime lending rates are set according to the RBI guidelines. The RBI sets the base rate below which no lending institution can set its prime rate. The prime rate for a particular financial institution is set by its management according to various factors such as funding costs and operating expenses.
Various other factors, such as market conditions, inflation rates, global economic conditions, and currency exchange rates can also impact the prime lending rate in India.
All these factors, in combination, determine the spread, which is the additional cost lenders consider in addition to the Repo Rate. The prime lending rate added to the spread determines the interest rate for consumers.
Loans Not Affected by Prime Lending Rate
Changes in the prime rate do not affect existing loans or lines of credit with fixed interest rates. This includes loans like student loans and mortgages, as well as credit cards issued with fixed rates.
How Prime Lending Rate Affects Personal Loan
The prime rate serves as a benchmark for lending rates, and it may affect personal loan interest rates. An increase in the prime lending rate may also increase personal loan interest rates, increasing the loan repayment amount.
Changes in the prime lending rate can thus affect the affordability and cost of borrowing these loans.
Difference Between Prime Lending Rate and Base Rate
The base rate, introduced in July 2010, is the minimum interest rate set by the RBI for giving out loans. RBI controls the base rate to enhance transparency, keep the economy in check, and ensure that consumers are not charged discriminately.
The following table illustrates the differences between prime lending rate and base rate:
Features
Prime lending rate
Base rate
Purpose
Serves as a reference point for financial institutions to set interest rates on loans for their most creditworthy consumers
Serves as a benchmark for financial institutions to calculate interest rates for various loans
Determinant
Influenced by changes in the RBI’s policy rates, credit risk, and market conditions
Influenced by the RBI’s monetary policy, economic conditions, and cost of funds
Flexibility
Typically set by the lending institutions as a fixed percentage above the RBI’s policy rate
Lending institutions are allowed to add a spread to the base rate to calculate the actual lending rate
Used for
Primarily used for loans offered to the most creditworthy consumers
Used for a wide range of loans, such as housing loans and MSME loans
Creditworthiness
Directly influences the interest costs of the most creditworthy consumers for loans with prime interest rate
Influences interest costs for loans with variable interest rates tied to the base rate
Transparency
Provides transparent benchmark for certain interest rates
Increases transparency in lending rates and ensures fair pricing
Adjustment frequency
Adjusted by lending institutions in response to changes in market conditions and RBI’s policy rates
Adjusted by lending institutions according to changes in the economic conditions and the RBI’s policy rates
Regulation
Regulatory scrutiny ensures transparency and prevents discriminatory lending practices
Regulatory oversight ensures fair lending practices and adherence to RBI guidelines
Risk considerations
Considers the credit risk of lending funds to the most creditworthy consumers
Considers the overall economic risk and cost of funds for financial institutions
Wrapping Up
Understanding the meaning of prime interest rate can help you gain an edge in securing loans. With a good credit score and financial profile, you can get loans at better interest rates than the general populace and fulfil your financial dreams, like buying a new bike.
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What is the difference between interest rate and prime rate?
The interest rate is the percentage that determines how much interest you will pay on a loan in addition to the principal amount. On the other hand, the prime rate is the base interest rate used by financial institutions to determine interest rates for loan products.
How to calculate prime rate?
The prime rate is generally calculated by adding 3.0 percent to the federal funds rate. In India, the Marginal Cost of Funds Based Lending Rates (MCLR) or the Repo Rate is typically used as a benchmark for setting lending rates rather than the prime rate. The Repo rate is set by the RBI, while the MCLR is calculated according to the loan tenor and the lending institution’s cost of funds.
Who sets the prime rate?
The prime lending rate in India is set by the Reserve Bank of India (RBI). By setting the minimum rates at which loans are given, the RBI keeps the economy in check and ensures that all customers are treated fairly.
20 February 2025
5 mins read
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