The ups and downs of base rate

An explanation of "prime rate".

If you're in the market for a big loan - a home equity line of credit or a credit card, for example - you have probably heard somebody spouting off about the "base rate" or "prime rate". Generally speaking, the base rate is the interest rate considered by banks to be the lowest rate they can offer on loans above the so-called risk-free rate available on government-backed securities that theoretically cannot go bust. If government debt is yielding 2 per cent, in other words, the base rate might be 3 per cent - a realistic scenario these days, considering how low central banks across the globe have pushed their own borrowing rates.

Many banks use the base rate, which is sometimes referred to as the benchmark rate, as a basis for setting interest rates on loans. If you want to take out a line of credit against your house, you might hear about a loan at 3 per cent above the base rate, which would come to 6 per cent per year in the example above. That's why consumers tend to watch base rates closely; it's these rates, not central bank decisions, that affect the actual interest rates on loans.

The prime rate is similar to the base rate, but is in more common use in the US and Canada and is set on a more formalised basis than base rates, which can vary widely from bank to bank. In the US, prevailing prime rates are published on a regular basis in The Wall Street Journal, which gets its figures by polling a basket of large banks. The prime rate is usually somewhere around 3 percentage points above the federal funds rate, which is set by the US Federal Reserve and watched closely all over the world. Currently the prime rate in the US is 3.25 per cent; the federal funds rate is now at roughly 0.25 per cent.

Here in the UAE, some banks use base rates as the foundation of interest rates on loans, but a far more common substitute is EIBOR, or the Emirates Interbank Offered Rate. EIBOR is simply an average of what banks charge when they lend money to each other, and it serves as a useful and convenient way for banks to price loans. Banks make money on the spread between the cost of capital (borrowing it at 3 per cent, say, or attracting deposits by offering 4 per cent interest) and the interest rates on loans.

So if a bank can charge EIBOR plus 3 or 4 per cent, it can expect to make about that amount in interest on its loans. [e-mail]