The prime interest rate is the interest rate that 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.
But when you run into the term “prime interest rate” in your daily life (maybe you’re taking out a personal loan or applying for a mortgage), it’s pretty common to feel a little confused, unless you majored in economics in college.
To get a better handle on this financial term and know how it relates to your money, read on. You’ll learn how this interest rate is set, a bit about its history, and how it can impact you.
How Is the Prime Interest Rate Set?
You’ve just learned that the prime interest rate is the rate that banks charge their best customers. Take a closer look at how the prime interest rate is set, as well as how this figure fits into the larger financial landscape.
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.
Why do banks lend each other money? They do so 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.
How Does the Prime Rate Compare
Generally, the prime rate is about three percent higher than the federal funds rate. That means that when the Fed raises interest rates, the prime rate typically goes up as well.
Because the prime interest rate is typically aligned with the federal funds rate, it’s highly susceptible to change. How often could the prime rate change? It can shift quite a bit. Take, for instance, the fact that the prime rate was 3.25% on March 16, 2020. From that date to July 2023, it rose 11 times to 8.50%.
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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. Consider some of the ways this can impact personal finance and the economy:
• Changes in the federal funds rate and prime interest rate can impact variable rate credit cards, adjustable-rate mortgages, home equity lines of credit (HELOC), and more. The interest rates on variable loans are based on these market interest rates and therefore change over time. In fact, 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.
• Historically, when the prime rate is low, the economy grows. That’s why, if there’s a recession, rates may go down, with the goal of getting consumers and businesses to borrow again and stimulate the economy.
When the prime rate is high, economic growth slows down. For instance, recently interest rates were raised, which can nudge consumers to think twice about spending. This can lower demand and help bring down inflation’s impact.
• 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 sync, this can be an indicator of an issue with the financial markets.
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An increase in the prime rate and federal funds rate can be an indicator that changes are ahead for consumers. Variable rates may be on the rise, too, so think carefully about how that might impact your finances.
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