What Are Prime Rates?

The prime rate is the best interest rate that major banks extend to their borrowers with the best credit, who pose the least risk. Currently, the prime rate sits at 3.25%. After the Federal Reserve responded to the worsening Covid-19 crisis by slashing interest rates one full percentage point to close to zero on March 15, major banks lowered the prime rate from 4.25% to 3.25%. Since then, the Fed has kept its rate close to zero, and with central bank policymakers forecasting that there would be no adjustments in rates through 2022, it could be a long time until the prime rate moves. A very common misunderstanding is that the Fed sets the prime rate. It does not, but there does exist a very close relationship between the prime and the federal funds rate that the Fed controls. In this article, I provide you with everything that you need to know about the prime rate and how it can affect you and your finances.

What is the Prime Rate?

The prime rate is the rate that commercial banks offer to their most creditworthy or least risk worthy customers, including both corporations and consumers alike. Borrowers who are considered more likely to not pay back a loan or default, receive higher rates. It is a very important lending rate that is used to set many variable interest rates, including the rates on credit cards and home equity lines of credit. Technically, there is no single prime rate as each bank sets its own, but they are generally all the same and move in lockstep with the federal funds rate.

Determining the Prime Rate

The prime rate moves with the Federal funds rate, which is the interest that banks charge each other for overnight loans so they can meet their reserve requirements. Generally speaking, banks will take that rate and add 3 percentage points to get their prime rate. It is important to note however, that the central bank does not exactly set the federal funds rate. It is ultimately set by the market forces of supply and demand, but the Fed’s policy making panel—the Federal Open Market Committee, or FOMC for short—establishes a target range for the rate. The current federal funds rate target is a range of 0% to 0.25%, matching the all-time low target rate set forth during the Great Recession. Today, the prime lending rate is 3.25%, which is 3 percentage points above 0.25%, the top of the Fed's target range.

How Does the Prime Rate Affect You?

The prime rate directly impacts variable-rate loans. If you have credit cards or a home equity line of credit, you feel the movements in the prime rate most closely, as rates on those products change in tune with the prime rate. For example, a credit card might have an APR (annual percentage rate) described as “prime plus 11.49%.” The rate on that hypothetical credit card would have dropped from 15.74% to 14.74% when the prime rate fell from 4.25% to 3.25%. Similarly, the adjustable rate on a home equity line of credit might be advertised as “prime plus 1%,” for example. 

Many adjustable-rate mortgages, or ARMS, also adjust alongside the prime rate, where the interest on those loans is fixed for the first several years, and then it moves up or down along with a benchmark interest rate. For example, a common adjustable-rate mortgage is the 5/1 ARM, meaning that your rate is fixed for five (5) years and can be adjusted every (1) year after that.

And while the rates on popular fixed-rate mortgages are not directly impacted by the prime rate and the federal funds rate, those rates do have an indirect effect on the mortgage rates borrowers pay. More recently, as the Fed has cut its rate to near zero, thus creating a climate for very low interest rates, mortgage rates have dropped to the lowest levels in history.

Conclusion

Understanding how the prime rate moves can be crucial. As always, timing is key when deciding to borrow money. If you are in the market for a mortgage, an auto loan or a personal loan, try to latch onto a lower rate if you can. This could be the differentiator in saving tens, and even hundreds of thousands of dollars.