Understanding the Prime Rate
The Prime Rate is an interest rate set by banks that is used to calculate interest and assess risk to their most credit-worthy customers. It is the rate used for almost all variable products they offer and is the most widely used interest benchmark. The prime rate itself is based on the Federal Funds Rate which is set by the Federal Reserve. Currently set at 3.25%, the rate since December of 2008, the prime rate is at its lowest level since the early 1950’s when it fluctuated between 2.25% and 3.0%. In the U.S., the prime rate runs approximately 300 basis points (or 3 percentage points) above the Federal Funds Rate, the rate that banks charge to each other for overnight loans made to fulfill reserve funding requirements: (federal funds rate) + (3 %) = (prime rate).
All borrowers are affected by the prime rate. It is used as a benchmark rate for home equity lines of credit, credit cards, many private student loans, business loans and variable rate mortgages. Rather than quoting an interest rate outright, banks will quote a loan rate as a margin over prime: (P+2.5% for example.) As banks have found the need to increase interest rates on home equity lines of credit and credit cards, rather than increasing the prime rate, they will increase the margin above prime. If the Federal Reserve decides an increase in the Federal Funds Rate is necessary, all the previously mentioned loan interest rates will increase shortly thereafter.
Since variable bank products are quoted as a margin over the prime rate, you will usually never see a change in your interest rate as long as the prime rate stays fixed. This is great news for home equity customers who took their lines around 2008 when the margin was actually below the prime rate. These people are generally enjoying rates of less than 3%, while those who took their lines in the last 18 months are probably experiencing rates of between 4.5% and 5.5%.
In this fragile economy, with many homes in foreclosure and many more homeowners on the brink of being unable to pay their mortgages due to job losses or other financial difficulties, an increase in the prime rate could well result in a large number more foreclosures across the nation. For this reason most market analysts expect the prime rate to remain at its current level for the near future.
Your credit score is the most important factor for a bank deciding your margin over the prime rate. Credit cards for example will give rates of Prime + 9.99% to their top clients and Prime + 16.74% for those who barely qualify for a variable credit product. Therefore keeping your credit history in good shape will ensure you do not pay unduly high interest rates when you need to borrow money. Beware when reading your credit card disclosures that you understand the rate you see on the disclosures in a margin over prime and not the actual rate you will pay.
So the prime is a useful and stable indicator of interest and why it is the most commonly used loan rate in banking today.
