When it comes to interest rates for consumers, there’s one thing that can have a major effect, that you might not have heard of: the prime rate. But what is the prime rate and how does it really affect you?
The prime rate affects nearly all financial products available for consumers. Read on to learn more about what the prime rate is, what it is today, and how it affects you and your money.
What is the prime rate?
The prime rate refers to the interest rate that commercial banks charge to their top creditworthy customers. Creditworthy customers are typically considered ‘prime borrowers’ and score the best interest rates.
According to the credit bureau Experian, “Prime borrowers are candidates who are considered most likely to make loan payments on time and in full, while subprime borrowers are considered more likely to default on their loans.” To be considered a prime borrower, your credit score needs to be 670 or greater.
So basically, the prime rate refers to the best prime lending rate that can be offered and is actually related to the federal funds rate.
What is the federal funds rate?
The Federal funds rate is established by The Federal Reserve and influences the prime rate. The federal funds rate refers to the interest rate that banks use when lending their cash reserves overnight.
According to the Federal Reserve Bank of St. Louis, “When a depository institution has surplus balances in its reserve account, it lends to other banks in need of larger balances. In simpler terms, a bank with excess cash, which is often referred to as liquidity, will lend to another bank that needs to quickly raise liquidity. The rate that the borrowing institution pays to the lending institution is determined between the two banks; the weighted average rate for all of these types of negotiations is called the effective federal funds rate.”
The Federal Open Market Committee (FOMC) sets the federal fund rate. This rate affects other rates, including the prime rate. The Federal Reserve notes that The Federal Open Market Committee (FOMC) meets approximately every six weeks or so, for a total of eight times per year, though the group can meet as required by any new financial or economic developments that need tending to.
How the prime rate works
So the prime rate is inextricably linked with the federal funds rate. According to the Federal Reserve, “The prime rate is an interest rate determined by individual banks. It is often used as a reference rate (also called the base rate) for many types of loans, including loans to small businesses and credit card loans.”
The prime rate is typically around 3% higher than the federal funds rate. So the next time you see headlines about “The Feds lower rates”, it’ll affect the prime rate as well.
So when it comes to interest rates on financial products, you can look to (or blame) the prime rate. This rate is determined by banks, not the Federal Reserve directly. However, the rate is based on the federal funds rate which is set by the Federal Reserve. In other words, they’re all interconnected and affect each other, and then affect you as a consumer (more on that later).
What is the current prime interest right now?
As of January 2021, the current prime rate is 3.25%, based on data from The Federal Reserve. In 2020, the Federal Reserve slashed interest rates to practically nothing (0%-0.25%). Given the formula we learned above, the prime rate is 3 percentage points more, so it makes sense the prime rate now is 3.25%.
The last time this happened before the global pandemic in 2020 was during the Great Recession of 2008. For reference, the prime rate has shifted throughout the decades and as of June 1984, the prime rate hit 13%, according to data from JP Morgan Chase.
Though each bank has its own prime rate, you can check out The Wall Street Journal Prime Rate, which aggregates the prime rates of the 10 largest banks.
How the prime rate affects your money
Though the terms “prime rate” and ‘federal funds rate” may sound stuffy and you may think they only affect banks, they actually affect your finances as well. The prime rate is used as a benchmark point for many lenders who offer financial products.
Fixed interest rates tend to follow the current prime rate and whatever rate you’re given remains the same (hence, fixed). On the other hand, you have variable interest rates that can move up or down based on the prime rate changes. That’s one of the good or bad things about variable rates.
When you have a variable interest rate, it can change based on what’s going on with the economy and the world. In this case, the variable rates are influenced by the prime rate, which is influenced by the federal funds rate.
Lenders may base their interest rates on the prime rate plus a certain percentage. So if the prime rate rises, you can expect that your variable Annual Percentage Rate (APR) will rise too. The converse is also true, so if the prime rate drops, variable APRs may drop as well.
Consider the situation now where rates are historically low. That is the case to encourage borrowing and to keep the distressed economy afloat. Here are some of the financial products that are affected by prime rate changes.
The prime rate can affect adjustable-rate mortgages. If the prime rate goes up, the rates can spike. In times like now where the rates have dropped dramatically, adjustable-rate mortgages may be lower. In other words, it could be a good time to borrow or refinance.
Personal loans can be used to cover unexpected expenses, help complete home renovation projects, or as a debt consolidation tool. Variable interest rates on personal loans shift in either direction based on the prime rate.
Credit cards have steep interest rates. The APR on credit cards could be based on a percentage plus the prime rate. Of course, the rate you’re given is also dependent on your credit score and creditworthiness as well.
Auto loan interest rates are also not immune to the power or the prime rate. Like the other financial lending tools, auto loan variable interest rates may swing based on what the prime rate is doing.
Aside from the federal funds rate and the prime rate, there is another rate that influences rates for consumers and that is LIBOR.
LIBOR refers to the London Interbank Offered Rate, which is used by many international financial institutions. This particular rate can also be used as an index to affect variable or adjustable interest rates.
However, LIBOR will stop being used this year. As it affects many interest rates as well, there could be shifts coming up.
According to the Consumer Financial Protection Bureau (CFPB), “To prepare for the anticipated discontinuation of LIBOR, financial institutions have been developing plans for the transition to replacement indices for new and existing loans that use the LIBOR index.”
Basically, this major index is coming to an end and will no longer be used as a benchmark point, and financial institutions are working on other options. Keep your eyes peeled for any shifts as it could potentially affect rates.
Generally speaking, the prime rate, the federal funds rate, and LIBOR move in the same direction.
How you can become a prime borrower
Though the prime rate indirectly affects you with the consumer interest rates you receive, you don’t really have control over it. So whether it goes up or down, there’s nothing you can really do.
However, there is something you can do that can help and that is to become a prime borrower. Interest rates are based on the prime rate but obviously, your credit score affects the interest rates you get approved for as well.
If you have a higher interest rate, you could end up paying more over time in interest so it makes sense to work toward improving your credit score.
You can do that by making payments on all of your debt obligations on time. Pay off your credit cards in full, if you can. Keeping low balances will help keep your credit utilization low which can help your credit score.
Another good idea is to keep tabs on your credit and make sure there are no mistakes on your credit report that can affect your score. You can access all three of your credit reports from each of the credit bureaus (Experian, Equifax, and TransUnion) at AnnualCreditReport.com.
The bottom line
The prime rate is something that affects financial markets and interest rates, which means it has an effect on you. It can influence the rates you get which have a long-term impact on your money. While you may have no say in the prime rate, you can work toward being a prime borrower so you can get the best rates possible when you need to borrow.