What Is The Prime Rate And How Does It Affect My Finances?
4-minute readSeptember 20, 2020
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If you’ve ever gotten a loan for anything, you might think the setting of interest rates is arbitrary. Usually, however, it’s anything but arbitrary. The rates charged to consumers are relative to a bank’s prime rate.
But what is the prime rate? Who sets it? What does it affect? Why does any of this matter? Keep reading and we’ll answer all those questions.
Prime Rate Definition
The prime rate is the base interest rate that banks charge for members with the best credit, usually large businesses. Each institution sets its own prime rate based on analysis of the competition and how much margin they feel comfortable taking.
It’s usually closely based on the federal funds rate, which is set by the Federal Reserve. This is the rate at which banks lend their money overnight to other banks to make sure that they have enough cash on hand to meet all the needs of their depositors.
Sometimes the prime interest rate is referenced directly in the terms of a loan. For example, you might see a line of credit, adjustable-rate mortgage (ARM) or other loan having a variable interest rate of “Prime plus 3.” That means the rate on your loan will vary with the prime interest rate. If the prime interest rate is at 3.25%, then your loan will have an interest rate of 6.25% (“Prime plus 3”).
When the prime rate is referenced, it typically won’t be written in numerical form into the contract because it can go up or down based on market conditions in any given time. In other cases, the interest rate for a loan may not mention the prime rate directly, but it still factors into the interest rate of just about every loan out there!
Current Prime Interest Rate
Because individual financial institutions set their own rates, there is no one number that represents the current prime interest rate. However, one place you can rely on for a good approximation is the WSJ prime rate survey. It looks at the best available corporate bond rates as listed by seven of the 10 largest financial institutions.
You might notice is that the rate hasn’t been updated since March 16, 2020. That happens to correlate with the day after the last time the Federal Reserve made a move with the Fed Funds Rate; banks base their rates off this Fed funds rate as a starting point.
Who Sets The Prime Rate?
Individual banks set their own prime rate. However, the prime rate is usually calculated based on the federal funds rate. The federal funds rate is set by the Federal Reserve System based on the overall market and macroeconomic conditions. When you hear in the news about “the Fed” cutting or raising interest rates, they’re referring to the federal funds rate.
The Federal Reserve is constantly monitoring the economic conditions inside the United States. Their goal is to set the prime interest rate such that the economy grows but doesn’t grow too fast. The prime rate history shows that when the economy starts slowing down or threatens to contract, the Federal Reserve will lower interest rates in an attempt to spur the economy. On the other side, if the economy is growing too fast, the Federal Reserve may raise the federal funds rate to try and hold off inflation.
In setting the prime rate for their institution, banks will add the federal funds rate to their chosen margin. That becomes the rate they give their most creditworthy clients, usually well-capitalized banks. It’s important to note that while banks have some flexibility in setting the margin, they also can’t be that out of whack with what everyone else is offering because you would just go down the street to the next bank offering a lower rate.
Historical Prime Rates
Prime rates are currently around 3.25%, according to the Wall Street Journal. In the past, the prime rate has been right around this level at various points ever since the data has been tracked. The rate has also been higher than 20%. This was back in the early ’80s.
You’ll find that the movements of the prime rate have historically tracked with the movement of the federal funds rate. That tends to go in cycles that are based on things happening in the economy. In the ’80s, the Fed was trying to get rampant inflation under control and dramatically raised interest rates as a result. There’s no rock-solid predictable movement pattern to these cycles.
Most recently, the Fed has chosen to keep the funds rate between 0% – 0.25% in order to stimulate the economy as it recovers from COVID-19. This has led to the prime rate being where it currently is. Projections from the Federal Reserve have a move in interest rates coming as soon as early 2022. As those rates move up, it would be fair to expect a corresponding move in prime rates.
How Prime Rate Affects You
A consumer is unlikely to get the prime rate as an interest rate. However, consumer interest rates are impacted by the prime rate given to the most creditworthy businesses. Let’s take a look at things that are and aren’t impacted by the prime rate.
What Prime Rate Affects
The primary impacts certain products. These include the following:
- Credit cards: The interest rate you pay for credit card balances is tied to your annual percentage rate (APR). The APRs for most credit cards are variable from month to month and tied directly to the bank’s prime rate.
- Adjustable-rate mortgages (ARMs): ARM rates tend to be based on things like this Secured Overnight Financing Rate and Constant Maturity Treasury. These in turn are influenced by the federal funds rate which many prime rates are based on. Home equity lines of credit (HELOCs) are also influenced the same way. The difference is that HELOCs change much more often than ARMs.
What Prime Rate Does Not Affect
As we mentioned earlier, most interest rates in the U.S. are either directly or indirectly related to the prime rate. However, there are some interest rates that the prime rate does not affect.
- Federal student loans: These rates are set and evaluated periodically by Congress in conjunction with the president during a normal legislative session.
Why The Prime Rate Matters
You may not think that the interest rate at which banks lend money to each other would have much of an impact on your day-to-day life, but these basic interest rates do trickle down even to the average consumer. Since many credit cards and other loans have interest rates tied to the current prime rate, it can affect how easy or difficult it is to pay off debt. When the prime rate is low, it’s easier to get a loan (at a lower interest rate!) than it is when the prime rate is high.
If you’re not sure whether your credit card or other loan is tied to the prime rate, you can check your monthly statement – it will show how your APR is calculated and what rate it’s tied to.
The Bottom Line
Most people aren’t familiar with the prime rate as a topic of everyday conversation, but this rate that banks charge their best corporate clients has a domino effect on every other interest rate charged by the bank. This is because the consumer interest rate is usually the prime rate plus a margin.
The prime rate itself is based on the Fed funds rate, the rate that lenders use when they borrow money from each other to cover deposits. Right now, the Fed funds rate is really low, and some prime rates charged by lenders will be low. It’s a great time to consider refinancing your mortgage to get a lower interest rate.
Rocket HQSM has partnered with CardRatings for our coverage of credit card products. Rocket HQ and CardRatings may receive a commission from card issuers. Opinions, reviews, analyses & recommendations are the author’s alone, and have not been reviewed, endorsed or approved by any of these entities.
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