An interest rate is the amount charged on money borrowed or lent and is usually expressed on a per year basis. Interest rates can be either variable, meaning that the amount of interest charged varies due to the market, or fixed, meaning that the amount of interest charged will never change. There are three forms of interest rates: prime interest rate, nominal interest rate, and discount rate.

Historically, the prime interest rate is the lowest interest being charged at a specific place and time and is offered only to preferred customers. The interest rate charged by a bank is largely based on the risk of default that a borrower poses. A bank’s best customers obviously have a very low risk of default and thus the bank is able to afford to give these customers the best possible interest rate. These best customers are usually corporations.

The prime interest rate is usually approximately 3% above the federal funds rate, the rate by which a bank lends immediately available funds to another bank overnight. The Federal Open Market Committee meets eight times a year specifically to set the federal funds rate and the prime rate. The prime rate does not change on a regular basis as other interest rates do, only when banks come together and decide it must be changed. The prime interest rate is often used in order to measure a nation’s economic success and serves as the measuring stick for all other forms of interest rates.

The nominal interest rate, also known as the stated interest rate is a predetermined interest rate and often less than the effective interest rate which is the actual interest paid. This form of interest rate does not take inflation or any other factor into account and therefore is unreliable. In order to come up with the real interest rate we merely take the nominal rate and subtract form it the rate of inflation.

The effectiveinterest rates, mentioned above, is the interest rate on a loan that takes the nominal interest rate and adds to it annual compounded interest. It’s also known as the Yield. It is different from the annual percentage rate because it usually does not incorporate one-time charges or other anomalies. Also, the effective interest rate does not have a legal definition. Its main purpose is to make loans easier to compare by converting any loan into the equivalent annual rate because different loans have different compounding terms. Keep in mind that the effective interest rate can be differently depending on the situation.

Lastly, there is the discount rate. This rate is what the Federal Reserve charges member banks on loans and determines the present value on future cash flows. This is a very limited form of borrowing and is usually pursued only after other means have been attempted. Each Federal Reserve Bank presents its discount rate to the board I order to be approved; therefore, not all discount rates will be the same for all 12 banks.