What is the prime rate?

The United States Federal Reserve bank, in Washington, D.C., which sets rate that can have an impact on the prime rate. The United States Federal Reserve bank, in Washington, D.C., which sets rate that can have an impact on the prime rate. Image:

In a Nutshell

The prime rate is a guiding interest rate that lenders reference when they set interest rates for consumers on things like credit cards, loans or mortgages. But who or what decides the prime rate, and how does it affect you?

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The prime rate is a base interest rate that plays an important role in determining lending rates that many banks and other lenders charge consumers.

Have you ever wondered how interest rates are set for the money you borrow? They’re typically based on the prime rate. When the prime rate goes up or down, consumer interest rates are likely to do the same.

Read on to learn more about the prime rate and how it can affect your personal finances.

What is the prime rate, and who sets it?

When it comes to lending, financial institutions charge interest on loans in exchange for allowing you to borrow money. The type of loan you want and your creditworthiness will definitely influence the rate you get — but the base, or starting point, for lenders is usually the prime rate. Here’s how it works:

  • The Federal Reserve System — the central bank of the United States, aka “the Fed” — has a committee that keeps tabs on the economy and sets what it thinks is a healthy target rate at which banks should lend each other money. This is known as the federal funds target rate.
  • When banks lend one another money to keep up their reserve requirements (an ongoing routine for them), they set their rates with the federal funds target rate in mind, using a standard formula: the federal funds target rate + about 3%.
  • The Wall Street Journal surveys the largest U.S. banks for the rate most of them settle on — and publishes this consensus rate as the prime rate.

The Federal Open Market Committee — that’s the committee that sets the federal funds target rate — meets at least eight times a year to discuss and possibly make rate changes.

How the Fed’s interest rate hike could affect your money

Why is the prime rate important?

Whether you’re taking out a mortgage or a personal loan, the interest rate is what determines just how much you’ll pay overall to borrow that money.

The prime rate is important because it’s a behind-the-scenes player that lenders typically use to set interest rates for consumers. In particular, the prime rate will likely have an impact on consumers with existing loans that have adjustable interest rates. Mortgages and credit cards can both have adjustable interest rates.

For example, if your credit card has a variable APR that changes with the prime rate, your rate will fluctuate along with the prime rate. If the prime rate goes up, it’s more than likely that variable APRs will, too.

Prime rate examples

The federal funds rate and the prime rate are tied to one another. The prime rate, then, is not a set number — it fluctuates when the Fed changes the federal funds target rate.

As a rule, the prime rate is about 3% greater than the federal funds rate (remember the formula described above that banks use). As of June 2018, the federal funds rate was set at 1.75%–2%. That made prime rate 5%.

The prime rate can vary depending on economic conditions. In December 2008, in the midst of the 2008 financial crisis, the prime rate was 3.25%, as the Fed had dramatically lowered the federal funds target rate to try to stimulate the economy.

Bottom line

“Prime rate” may not be a household term, but it is an everyday consumer concern, given its impact on variable credit card APRs, adjustable-rate mortgages and interest rates overall. When the prime rate shifts, it affects the lending environment — and it has an impact on how much consumers pay in interest for the money they borrow.

Keeping an eye on the prime rate and understanding how it can affect the interest rates you pay can empower you as a consumer, helping you figure out where things may be headed.

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