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Video — The Prime Interest Rate Explained Visually

66.6 seconds

"Prime has dropped (or raised) 0.X%" Youll see some version of that headline all the time, particularly if youre looking for a mortgage. You may even be considering a loan that is based on "Prime". But what is Prime??

In a nutshell, the prime lending rate is the interest banks charge each other for overnight loans. This rate is based in turn on the interest rate the Federal Reserve charges for money it lends to banks.

Heres an example from the video.

Bank A borrows money from the Federal Reserve, at 1% interest.

Bank B borrows from Bank A at 4% interest.

(Historically Prime has been about 3% above the Federal rate.)

Both Bank A and Bank B recalculate loans "based on Prime" — like Adjustable Rate Mortgages — on that 4% figure.

The short-hand term "above Prime" in the world of mortgages is the margin (or spread) added to the Prime rate. An ARM with 2% margin would be 6% (4% + 2%) in the example above.

Watch our short video to see this explained visually.

How Is The Prime Rate Set?

TL/DR

The interest rate that commercial banks charge customers who have good credit is known as the prime rate. This rate is derived from the federal funds overnight rate that is set by the Federal Reserve. The current prime rate is typically calculated by adding three percentage points to the fed funds rate. The rate is used as a foundation for calculating other types of interest rates, such as those used for mortgages, small business loans, or personal loans.

In Detail

The prime rate is the interest rate that commercial banks charge their most creditworthy customers. It is sometimes referred to as the prime lending rate. The Federal Reserve (Fed) is responsible for determining the federal funds overnight rate, which then becomes the foundation for the prime rate, which in turn becomes the point of departure for all other interest rates.

When banks and other lenders are determining the interest rates that will be applied to various products, such as credit cards and home loans, the benchmark that is utilized most frequently is the prime rate, which is also known simply as "prime" in some instances.

Key Takeaways

  • The interest rate that commercial banks charge their corporate clients that are deemed to have the highest creditworthiness is referred to as the prime rate.
  • The federal funds rate serves as the basis for determining the prime rate.
  • The current prime rate is typically calculated by adding three percentage points to the fed funds rate.
  • The prime rate is the benchmark for determining interest rates for mortgages, loans to small businesses, and personal loans.
  • Lenders often charge the prime rate to customers with the highest creditworthiness, while customers with lower credit scores receive an interest rate that is prime plus another percentage point based on their score.
  • The prime rate that is used the most is the rate that is published each day in the Wall Street Journal.

How the Prime Rate Is Calculated

Interest rates are expressed as a percentage of the total loan amount and are levied by lenders on any loans they make available to borrowers. It serves as a type of compensation for the risk that lenders assume based on the borrower's credit history and other financial facts, and it plays a role in the lending process. 2 In most cases, these rates are reported on an annual basis as the annual percentage rate (APR).

The prime rate is the interest rate that commercial banks charge their most creditworthy customers, who are typically major enterprises. The federal funds rate, which is established by the Federal Open Market Committee, is a significant factor in determining the prime interest rate, which is often referred to as the prime lending rate (FOMC). The interest rate that commercial banks charge one another for overnight loans is known as the fed funds rate. 1 When calculating the prime rate, banks will often utilize the sum of the federal funds rate and three additional percentage points.

As was mentioned earlier, the prime rate is the interest rate that creditors charge their most creditworthy customers for personal loans, small business loans, and mortgages. When it comes to the majority of other interest rates, the prime rate serves as the foundation or point of departure. The interest rate that is paid to these borrowers, which is calculated based on their credit scores and credit histories, is often the prime rate plus a predetermined percentage. Those who have a good credit score would be charged an interest rate for a credit card that is, for example, prime + 9%, but those with a lower score could be given an interest rate that is prime plus 15%.

Nearly all other interest rates are calculated by adding a percentage point to the prime rate as their starting point.

How the Prime Rate Is Determined

The prime rate is an interest rate that is decided by individual banks and is used as a base rate for many different sorts of loans, including loans to small businesses and credit card interest rates. Even though the Federal Reserve does not have any direct involvement in the process of determining the prime interest rate that banks use, many different types of financial institutions choose to determine their prime rates in part based on the target level of the federal funds rate that is established by the Federal Open Market Committee (FOMC). 1

The prime rate that is published each day in the Wall Street Journal is widely regarded as one of the most important. As was mentioned before, the prime rate is typically calculated by adding three percentage points to the fed funds rate. As of December 2022, the prime rate in the United States stood at 7.5%. 3 That represents an increase from the rate of 7% that had been established in November 2022. 4 In December 2022, the increase took place about the same time that the Federal Reserve raised the range of possible values for the fed funds rate to 4.25% to 4.5%. 5

Although other financial services institutions in the United States take note of any changes that the Federal Reserve makes to its prime rate on a regular basis and may use these changes to justify changes they make to their own prime rates, these institutions are not required to raise their prime rates in the same manner as the Federal Reserve.

The prime rate is subject to daily fluctuations, just like all of the other interest rates. On the website of the Federal Reserve, one can find a snapshot of the prime rate as of the current date.

What Effect Does the Prime Rate Have?

A wide variety of bank loans are impacted by the prime rate. When there is an increase in the prime rate, interest rates on credit cards, auto loans, mortgages, and small business loans, as well as lines of credit (LOCs), also go up.

Because a bank has the ability to adjust your rate, any debt that has a variable interest rate may be influenced by the prime rate. This covers credit cards in addition to mortgages, home equity loans, personal loans, and variable interest rate student loans. This also includes student loans with variable interest rates.

Only the most qualified customers, who represent the least amount of default risk, are eligible for the prime rate. This rate is reserved for those customers. It's possible that individual borrowers won't have access to prime rates, but larger entities, like corporations and established businesses, will. Even though the prime rate is established at 5%, a lender is not required to offer rates lower than 5% to consumers who have good credit because those prices are not regarded to be a statutory minimum.

What Kind of Influence Does the Prime Rate Have on Borrowers?

The prime rate is not a constant interest rate; rather, it fluctuates over time in response to shifts in the federal funds rate, inflation, the demand for loans, and other factors related to the economy. When there is a change in the prime rate, it is possible that there will also be a change in the interest rates on loans and other financial products that are dependent on the prime rate.

The prime rate can influence your finances in a variety of different ways, depending on the kind of loan or other financial product you have.

  1. Home equity loans: The interest rate on a borrower's home equity loan or home equity line of credit (HELOC) may be dependent on the prime rate if the borrower has a home equity loan or home equity line of credit (HELOC). If the prime rate goes up, the interest rate on the home equity loan might go up as well, which would mean that the borrower would have to make larger payments on a monthly basis.
  2. Adjustable-rate mortgages (ARMs): If a borrower has an adjustable-rate mortgage (ARM) that is related to the prime rate, then an increase in the prime rate might lead to an increase in the interest rate on the borrower's mortgage, which would result in the borrower having to make larger monthly payments.
  3. Credit card balances: If a borrower has a credit card with a variable interest rate, the interest rate may be based on the prime rate. This is because the prime rate is determined by the bank that is funding the borrower's credit card. If the prime rate goes up, the interest rate that you pay on your credit card can go up too, which would mean that the borrower would have to pay more in interest overall.
  4. Loans for small businesses: If a small business has a loan with an interest rate that is dependent on the prime rate, then an increase in the prime rate might potentially lead to an increase in the interest rate on the loan, which would result in higher loan payments for the business.

A Brief Overview of the Prime Rate's History

The prime rate has a long history that dates back to the 1930s century, when it was first used by banks to set the interest rates for short-term lending to their most creditworthy customers following the Great Depression. Since then, the prime rate has been used by banks to determine the interest rates for various types of loans. The prime interest rate maintained a consistent level in the decades that followed the end of World War II, ranging between two and three percent.

The prime interest rate, on the other hand, started to climb dramatically in the 1970s while the United States was going through a period of economic contraction and rising inflation. In December 1980, when the Federal Reserve attempted to limit inflation by hiking interest rates, the prime rate rose to its all-time high of 21.5%, setting a new record for itself.

Over the course of the following few decades, the prime interest rate experienced significant shifts that were mostly reflective of other benchmark interest rates and mirrored the ups and downs of the economy. The prime interest rate has a tendency to be greater during periods of economic expansion, whereas it has a tendency to be lower during times of economic contraction or financial turbulence.

How Has the Prime Rate Evolved Over the Course of Its History?

The prime rate is determined by the movement of the federal funds rate, which, in turn, frequently reflects the status of the economy. Over time, prime rates shift depending on this movement.

The prime rate in its most recent history has been as follows: 4

12/14/2022: 7.50%

11/03/2022: 7.00%

9/22/2022: 6.25%

7/28/2022: 5.50%

6/16/2022: 4.75%

5/5/2022: 4.00%

3/17/2022: 3.50%

3/16/2020: 3.25%

What Kinds of Interest Rates Are Unaffected by Changes in the Prime Rate?

A change in the prime rate will not affect any loans or lines of credit already in existence that have a fixed interest rate attached to them. This could include things like savings accounts, fixed-rate mortgages, and student loans.

What Kind of Message Does a Shift in the Prime Rate Send?

Whenever there is a change in the prime rate, it almost always indicates that the Federal Reserve has moved their fund rate. For instance, a rise in the federal funds rate may be implemented in order to combat the developing trend of inflation and maintain price stability.

What Was the Prime Rate That Was Recorded to Be the Highest One Ever?

In December of 1980, the prime rate reached its all-time high of 21.5% for the first time ever recorded.



Author
Cathy Hills
Content Associate
January 27, 2023
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