Whether you’re taking out a personal loan or applying for a mortgage, chances are you’ll inevitably run into the term “prime interest rate.” And, there’s an even stronger chance that you may not know exactly what it means at first.
Here’s the deal—a prime rate is the interest rate at which banks charge their best customers. It’s the lowest rate offered to individuals and corporations that are considered low risk by banks—those with good credit history who aren’t likely to miss payments or default on their loan.
How Is the Prime Interest Rate Set?
Individual banks determine their prime interest rate. While the Federal Reserve has no direct role in setting the prime rate, many banks choose to set their prime rates based partly on the target level of the federal funds rate.
The federal funds rate is the rate that banks charge each other on an overnight basis and is established by the Federal Open Market Committee.
The banks lend each other money in order to meet the reserve requirement , which is also set by the Federal Reserve. This is the minimum amount of cash a bank must have in their vault or at the closest Federal Reserve bank. If one bank has excess cash, the bank has a financial incentive to lend that excess cash to a bank that has less than its federally mandated amount. The reserve requirement acts as a lending limit for banks and also ensures that they have enough cash on-hand for the start of business each day.
The federal funds rate is changed for a variety of reasons—to decrease inflation for instance, or stimulate growth. In 2008, the federal funds rate was lowered to 0.25%, in order to encourage bank lending and mitigate the growing financial crisis. The highest the federal funds rate has ever been was 20% in 1980.
Typically, the prime rate is set about three percentage points higher than the Federal Reserve’s rate. Since each bank sets its own prime rates, a popular measurement of the current prime rate is the Wall Street Journal’s prime interest rate . This is determined by polling 30 of the largest US banks. If 23 of the banks have changed their prime rates, the Wall Street Journal prime rate will change as well.
Because the prime interest rate is typically aligned with the federal funds rate, it’s highly susceptible to change—The Federal Open Market Committee meets eight times a year, so prime rates may change accordingly. A look at the history of the prime rate in the last thirty+ years will show you how much variation can occur. Over the past few years, the Federal Open Market Committee has been increasing the federal funds rate. It was increased once in 2015, once in 2016, three times in 2017, and four times in 2018 . Current projections anticipate the federal funds rate could be up to 3.1% in 2021 .
Why Is the Prime Interest Rate Important?
The prime interest rate impacts all kinds of loans, including interest rates for mortgages, credit cards, auto loans, and personal loans. Typically, banks and lenders will use the prime interest rate as a benchmark for setting interest rates for their customers.
This can be especially relevant to consumers who borrow variable rate loans. Changes in the federal funds rate and prime interest rate can impact variable rate credit cards, adjustable rate mortgages, home equity lines of credit, and more . The interest rate on variable loans are based on these market interest rates and therefore change over time. Variable interest rates, including those on credit cards, are often expressed as the prime rate plus a certain percentage .
Unlike fixed-rate loans, monthly payments on any variable loan could change considerably from month-to-month. This is why fixed-rate loans can be a more desirable alternative than variable loans for some borrowers.
Though rates are largely influenced by the Federal Reserve, borrowers have little control or way of predicting the rates from year to year. Even when the Federal Reserve predicts growth, interest rates can rise due to a variety of factors , causing your monthly bill to rise with it.
Beyond individual borrowers, the prime interest rate also influences the financial market as a whole. A low prime rate makes it easier and less expensive to borrow loans which increases liquidity in the market.
The prime rate isn’t the only benchmark that banks use to inform interest rates. Banks also often use the London Interbank Offer Rate (LIBOR). The LIBOR is the rate that banks charge each other for short-term loans . The federal funds rate, prime interest rate, and LIBOR rates generally fluctuate together . When the three rates are out of synch it can be an indicator of an issue with the financial markets .
Personal Loans with SoFi
An increase in the prime rate and federal funds rate can be an indicator that changes are ahead for consumers . Pay attention to interest rates on personal accounts , especially if they have variable rates, as the federal funds rates and prime rates fluctuate. When those benchmark rates change, it might means adjustments to interest rates are just around the corner.
If you are in need of a personal loan, know that a variable rate loan isn’t the only option. At SoFi, you can borrow a fixed-rate, unsecured personal loan, and complete the application entirely online. A personal loan could also be an option for consolidating credit card debt. It could mean the opportunity to eliminate a variable rate credit card and even potentially decrease the overall interest rate on the debt.
When you borrow a SoFi personal loan, there are no prepayment penalties or origination fees. You’ll also gain access to other member benefits like career counseling and unemployment protection, which could potentially allow you to temporarily pause your payments if you unexpectedly lose your job.
With a personal loan, you’ll have access to the money you need quickly, and depending on your credit score and other personal financial factors, usually at a lower interest rate than most credit cards.
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