Different Types of Interest Rates

Understanding Base Rates Versus Prime Rates

Interest rates printed in newspaper
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There are a variety of different types of interest rates, but in order to understand these, one must first understand that an interest rate is a yearly price charged by a lender to a borrower in order for the borrower to obtain a loan, usually expressed as a percentage of the total amount loaned.

Interest rates can either be nominal or real, though certain terms exist to define specific rates such as the Federal Funds Rate. The difference between nominal and real interest rates is that real interest rates are ones that are adjusted for inflation, whereas nominal interest rates are not; the interest rates one typically finds in the paper are nominal interest rates.

The federal government of any given country can affect the interest rate, known in the United States as the Federal Funds Rate and in England as the Prime Rate, thought the effects of these changes are typically felt by the citizens of a country for some amount of time after it is implemented.

Understanding the Federal Funds Rate

The Federal Funds Rate is defined as the interest rate at which U.S. banks lend to one another their excess reserves held on deposit at the United States Treasury Department, or the interest rate that banks charge each other for the use of Federal funds in general.

"Investor Words" describes the Federal Funds Rate as an indicator of general interest rate trends, one of two rates controlled by the federal government, but cautions that "While the Fed can't directly affect this rate, it effectively controls it in the way it buys and sells Treasuries to banks; this is the rate that reaches individual investors, though the changes usually aren't felt for a period of time."

Essentially what this means for the average American is that when you hear that the Federal Treasury Chairman has "raised interest rates," they're talking about the Federal Funds Rate. In Canada, the counterpart to the Federal Funds rate is known as the overnight rate; the Bank of England refers to these rates as the base rate or the repo rate.

Prime Rates and Short Rates

The Prime Rate is defined as a rate of interest that serves as a benchmark for most other loans in a country. The precise definition of prime rate differs from country to country. In the United States, the prime rate is the interest rate banks charge to large corporations for short-term loans.​​

The prime rate is typically 2 to 3 percentage points higher than the Federal Funds rate. If the Federal Funds rate is at around 2.5%, then expect the prime rate to be around 5%.

The short rate is an abbreviation for 'short-term interest rate'; that is, the interest rate charged (usually in some particular market) for short-term loans. Those are the major interest rates you will see discussed in the newspaper. Most of the other interest rates you see will usually refer to an interest-bearing financial asset, such as a bond.