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What Is The Prime Rate And How Does It Affect My Finances?

4-minute readSeptember 21, 2020

An interest rate is the percentage that one party collects from another in exchange for letting them borrow or hold on to money. As a consumer, you may be familiar with interest rates in two different situations. First, as the rate that you have to PAY to a bank when they lend you money. This could be a mortgage, a car loan or money they are fronting you when you use a credit card. Second would be when you are giving the BANK money – this is usually in the form of a savings account or a certificate of deposit. In these cases, you give the bank money, and the bank pays you interest in exchange for the use of your money.

In this article, we’re going to talk about the prime rate, a special interest percentage used by banks as they lend to their biggest customers (usually large corporations). While you’ll never borrow or lend money directly with the prime rate, it does pay an important part in the interest rates that you DO use.

Prime Rate, Defined

The prime rate is the base interest rate that banks charge for members with the best credit, usually large businesses. It’s closely based on the federal funds rate. The federal funds rate 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”). 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!

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How The Prime Rate Is Calculated

The prime rate is 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.

Prime Rate Fluctuations

The Federal Reserve does not change the federal funds rate very often. They are attempting to keep a stable rate in place so that banks have a reliable figure to base the current Prime Rate on. The Prime Rate is around 3% higher than the Federal Funds rate set by the Federal Reserve. The Federal Open Market Committee typically only meets eight times a year, though they may convene emergency sessions if market conditions warrant. 

What the Prime Rate Doesn’t 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. Another index used by some lenders is LIBOR, the London Interbank Offered Rate. LIBOR provides an index rate for things like certain adjustable rate mortgages, among other offerings.

 

  • Federal student loans are mostly unaffected; instead lawmakers meet annually to determine each year’s student loan cost
  • Fixed-rate mortgages – While the current mortgage rates are affected by the prime interest rate, that only applies if you’re refinancing or getting a new loan. If you took out a fixed-rate mortgage, your interest rate is locked in for the term of your loan.
  • Credit cards with an annual percentage rate (APR) based on LIBOR – Some credit cards have their APR set by LIBOR instead of the prime rate.

 

It’s worth noting that LIBOR is being phased out as an industry standard. Lenders are making the transition to the Secured Overnight Financing Rate (SOFR) no later than the end of 2021, and much sooner in many cases.

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 is tied to.

A Final Word

Trying to navigate the process of getting loans and how the prime rate can impact your finances can seem overwhelming, but building a good relationship with a trusted financial advisor can help quite a bit. While you don’t need to spend your entire waking day poring over how the Federal Reserve board might change interest rates, it’s useful to at least have a basic understanding of what the federal funds rate is, what the prime rate is, and how they can impact your personal finances. Hopefully this article has helped achieve this understanding!

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