What Is The Prime Rate And How Does It Affect Me?

The interest rate a lender sets when you’re taking out a loan isn’t arbitrary. In fact, the rates charged to consumers are relative to a bank’s prime rate. We’ll break down what you need to know, including what is the prime rate and how it affects your loans.

U.S. Prime Rate Definition

The prime rate is the base interest rate that commercial banks charge for the most creditworthy borrowers. Each institution sets its own prime rate based on various factors (like how much their competitors charge) and how much of a buffer they feel comfortable taking.

The prime rate is usually closely based on the federal funds rate, set by the Federal Reserve. This is the rate at which banks lend their money overnight to other banks to make sure that they have enough cash on hand to ensure their depositors have access to their cash.

Sometimes the prime interest rate is referenced directly in the terms of a loan. For example, you might see a line of credit, adjustable-rate mortgage (ARM) or other loan having a variable interest rate of “Prime plus 4.” That means the rate on your loan will vary with the prime interest rate. If the prime interest rate is at 3.25%, then your loan could have an interest rate of 7.25%.

The prime rate typically won’t be written in numerical form when it comes to loan documents because it can go up or down based on market conditions at any given time. In other cases, the interest rate for a loan may not mention the prime rate directly. However, it still factors into the interest rate.

Why Banks Use The Prime Rate

Commercial banks use a prime lending rate mostly to ensure profitability. These institutions look at the Federal Reserve funds rate to encourage more borrowers or to ensure they’re earning enough from their loans to keep their operations afloat and profitable.

However, the prime rate is merely a benchmark for interest rates and is only one factor as to what the bank’s interest rates may be. As in, it could go higher based on the loan type, a borrower’s credit score and other factors. The annual percentage rate, or APR, is the “true” cost of a loan and typically includes lender fees in addition to the interest rate.

How The Prime Rate Works And Who Sets It

Individual banks set their own prime rate, typically based on the federal funds rate. The latter is set by the Federal Reserve (or The Fed) based on the overall market and macroeconomic conditions.

The Federal Reserve is constantly monitoring U.S. economic conditions. Their goal is to set the prime interest rate such that the economy remains stable. The prime rate history shows that when the economy starts slowing down or threatens to contract, the Federal Reserve will lower interest rates in an attempt to spur the economy. On the other hand, if the economy is growing too fast, the Federal Reserve may raise the federal funds rate to try and hold off inflation to cool the economy.

Banks will consider the federal funds rate and add an extra buffer, called the margin. This buffer is to help to decrease risk banks may have if a borrower defaults on their loan. The prime rate plus the bank’s margin is what the institution will offer to their most creditworthy clients. While banks have some flexibility in setting the margin, they’re typically close to what other competitors offer. That way, the banks won’t risk losing business if their rates are too high, or not be as profitable if their rates are too low.

Target Rate Vs. Prime Rate

While both the target rate and prime rate can change often, there are some significant differences between the two. The target federal funds rate is set by the Federal Open Market Committee (FOMC) and is what it believes will help achieve economic conditions or outcomes. The target rate from the FOMC is the amount banks need to hold onto in reserves and is the rate at which commercial banks can borrow from each other overnight.

What Prime Rate Changes Mean

Prime rate changes generally mean an increase or decrease in interest rates for loans and other financial products. An increase in rates is typically used to help cool the economy and fight rising rates of inflation, whereas lower rates are meant to encourage spending to boost the economy. For instance, 30-year historical mortgage rates from the mid-2020s to late 2021 saw some of the lowest interest rates in over 50 years in an attempt to boost the economy. However, as inflation rates have climbed, so have mortgage rates.

What The Prime Rate Doesn’t Affect

Most interest rates in the U.S. are either directly or indirectly related to the prime rate. However, there are some financial products that aren’t affected by the prime rate:

• Federal student loans: These rates are set and evaluated periodically by Congress in conjunction with the President during a normal legislative session. It typically doesn’t take into account the current prime rate.
• Fixed-rate loans: Whether it’s a mortgage, personal loan or auto loan, if the rate is fixed, it’s unaffected by prime rate changes. That’s because the rates are set when the loan was taken out by the borrower and are contractually guaranteed to be the same throughout the life of the loan.

How To Find The Current Prime Rate

You can find the current Fed prime rate on the Federal Reserve’s website. Other reputable resources such as the Wall Street Journal is another source to help you find the current approximate prime rate. However, no one particular number represents the prime rate across all banks since they’re the ones that ultimately set their own rate.

Why The Federal Prime Rate Matters To You

The prime rates affect business owners who are looking to take out loans or have one that carries a variable interest rate. That’s because the higher the prime rate, lenders typically feature higher interest rates on their loans. Loans that may be affected include credit cards, home equity lines of credit and ARMs.

Credit Card Debt

The interest rate you pay for credit card balances is tied to your annual percentage rate (APR). The APRs for most credit cards are variable from month to month and usually are tied directly to the bank’s prime rate.

Auto Loans

The higher the prime rate, the higher your auto loans could be. Banks want to ensure they decrease their risk as much as possible when lending money, so the prime rate is one the way it can help to do so.

Mortgages

ARM or adjustable-rate mortgage rates tend to be based on factors such as the Secured Overnight Financing Rate and Constant Maturity Treasury. These in turn are influenced by the federal funds rate which many prime rates are based on. During your introductory fixed rate period, your rate probably won’t change. Afterwards, your rate could fluctuate depending on factors like the prime rate — lenders will give you notice when that happens.

Home Equity Loans and Home Equity Lines Of Credit

You may see different interest rates if your home equity line of credit (HELOC) has a variable rate. If it’s a fixed rate, yours won’t change for the life of the loan. Same with home equity loans.

Small Business Loans

When taking out a new loan, small businesses may be affected by higher or lower rates depending on how the prime rates fluctuate. For fixed rates, small businesses will pay the same monthly payments until the loan is paid off or refinanced. However, if you took out a variable rate loan, your rate could change — you’ll typically receive an official notice ahead of the changes.

Prime Rate History

Prime rates are around 8.50% as of December 2023, according to the Wall Street Journal. Since tracking data, some of the highest rates have been around 18% at the end of 1980.

The movements of the prime rate have historically tracked with changes in the federal funds rate. For instance, in the 1980s, the Fed was trying to get rampant inflation under control and dramatically raised interest rates as a result.

In mid-2020, the Fed chose to keep the funds rate between 0% – 0.25% in order to stimulate the economy as it attempted to recover from the economic effects of COVID-19. The rate has risen dramatically since that time in an effort to combat high inflation.

The Bottom Line: The Prime Rate Impacts Many Borrowers

The prime rate is influenced by the Fed funds rate, the rate that lenders use when they borrow money from each other to cover deposits. Lenders use this rate to set rates for their loans, such as mortgages, HELOCs and small business loans.

While understanding the prime rate may not be an everyday concern for you, it’s important to keep tabs on it if you currently have a variable interest rate loan or you’re looking to take out a new loan in the next several months. To see how a current or future loan may affect your finances, consider using free tools such as the Rocket Money℠ app to track your budget and the overall status of your financial health.