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What Is The Prime Rate And Why Does It Matter?

11/4/19

Q: What exactly is the “prime rate?” How does it affect me as an individual?

A: The prime rate is the current interest rate that financial institutions in the U.S. charge their best customers. These customers have excellent credit, and are eligible for this optimal rate because their loans carry the lowest risk for their financial institutions.

The prime rate is also referred to as the prime interest rate, prime lending rate or simply prime. You may hear this term thrown around a lot in the financial news or when reading up on loans and mortgages. That’s because the prime rate affects every level of the economy.

We have answers to all your questions on the prime rate.

How is the prime rate determined?

The prime rate is based on another rate, which is set by the Federal Reserve Board. It’s an interconnected system starting with the government and ultimately impacting each of us on some level.

The prime rate is determined in three steps:

1.   The Federal Reserve System, which is the central bank of the United States, sets the federal funds target rate, or the interest rate, it thinks is best for financial institutions to use when lending each other money.

2.   When financial institutions lend each other money to maintain their reserve requirements, they base the interest rates they charge each other on the federal funds target rate.

3.   The Wall Street Journal surveys the largest financial institutions in the country to determine the rate they are using and then publishes this rate as the prime rate. This number is generally 3 percent higher than the federal funds target rate.

The fed’s target rate, and consequently the prime rate, changes often. In fact, the Federal Open Market Committee, which sets the federal funds target rate, meets a minimum of eight times a year to discuss possibly changing the target rate.

The prime rate increased significantly at the start of the 21st century, reaching a peak of 8.25% in the second half of 2006. It then decreased steadily until it reached a low of 3.25% at the start of 2009. Since then, it has remained relatively stable, fluctuating between its highest recent point of 5.50% in December, 2018, and its lowest recent point of 4.0% in March, 2017. On Oct. 31, 2019, the prime rate was 4.75%.

How does the prime rate affect the average individual?

There are two ways the prime rate affects you.

First, the interest rate on nearly every loan, including mortgages and credit cards, is affected by the prime rate. Financial institutions and large lenders will base their interest rates on the prime rate, generally establishing their current rates at an amount that is higher than prime to cover their larger risk of default. If the prime rate rises, the interest rates on your loans and adjustable-rate credit cards will rise as well.

Second, the prime rate affects liquidity in the financial markets. When the rate is low, liquidity increases. This means funds are more readily available because loans are less expensive and easier to qualify for. This, in turn, generates a growing economy as businesses expand.

Conversely, when the prime rate is high, liquidity is low and loans are hard to come by, thus slowing the economy down.

Is the prime rate the only factor used to determine individual interest rates?

While the prime rate is the starting point that financial institutions and large lenders use in determining an interest rate for a loan, it is by no means the only factor they’ll consider.

Your credit score plays a vital role in the interest rate you’ll be granted for a large loan. The higher your score, the lower interest rate you’ll earn. Keep your score high by using your cards responsibly and paying your credit card bills on time.

The prime rate is an important element in the overall state of the U.S. economy and in your personal finances as well. While you have no control over the rate’s rise and fall, you can do your part in keeping your interest rates low by maintaining a high credit score, living with financial responsibility and taking advantage of the excellent rates on products offered at Landings Credit Union.