The prime rate is the lowest interest rate lenders are willing to offer to their most trustworthy clients, while the federal funds rate is the interest rate banks may charge each other for overnight lending to one another. The Federal Reserve sets a minimum amount that financial institutions must withhold in the case of bank failure. The monetary policies of the Federal Reserve are made up by the Federal Open Market Committee, who are in charge of supervising open market operations. The Federal Open Market Committee is also responsible for meeting regularly to set the interest rates that are charged to banks. Thus, a higher interest rate will in turn causes the banks to charge higher interest rates to their customers. The Fed Funds Rate is used as a point of reference for all other rates, such as the prime interest rate in the United States.
The typical U.S. prime rate that an investor may come across is usually the result of one of two determination methods. It is either an average of all the prime rates of America's top banks and lenders, or the FFTR plus 300 basis points, or 3%. Since the standard benchmark most banks use to determine their unique prime rates is the FFTR, the two different methods of determining the U.S. prime rarely yield very different results. Additionally, since around the second quarter of 1994, the industry’s rule of thumb regarding the U.S. prime rate was to add 300 basis points to the federal funds target rate.
Note that lenders are only willing to offer the prime rate to their absolute most trustworthy clients on a verifiable basis that there is very little risk of default. For less creditworthy borrowers, lenders will typically use their prime rate as a base interest rate and then add a margin based mostly on the amount of risk associated with the deal in order to make a profit — the more risk involved, the higher the margin.