The prime rate is a key interest rate that influences most other rates. Here's how it moves, and how it affects your loans and credit cards

Karen Fernandez

Sep 9, 2020, 04:54 IST

The prime rate is a key interest rate that influences most other rates. Here's how it moves, and how it affects your loans and credit cards

While not an official interest rate, the prime rate acts as a harbinger for the state of the economy.RBFried/Getty Images

The prime rate, aka the prime, is the interest rate that banks charge their most creditworthy clients.
Though not set by the government, the prime rate runs about 3% higher than the Federal Reserve's federal funds rate.
Commercial banks use the prime as a basis for the interest they charge on consumer loans, credit cards, and mortgages.

The prime rate, aka the prime lending rate or simply the prime, is the interest rate that banks charge their biggest, most creditworthy corporate customers, along with very high net worth individuals. Think blue-chip stock companies or the likes of Warren Buffett.

But while the prime does not directly affect most consumers, it does provide the benchmark for many consumer and small business loans. It also affects other types of everyday debt, like credit cards, mortgages, and home equity lines of credit.

What is the prime rate?

The prime rate is an interest rate charged on loans. Much like any other interest rate, the prime exists to cover costs and losses associated with financing. It acts as the compensation for the multiple risks banks expose themselves to when extending credit to clients.

Only stable businesses with the highest credit ratings qualify for this prime interest rate, as they are the ones that pose the least risk of defaulting on their loans. As the name "prime" implies, it tends to be the best — that is, the lowest — interest rate the financial institution charges.

Although it's a variable, or floating, interest rate, the prime does not change at regular intervals. Rather, banks adjust it according to the shifts in the economy and the business cycle. The prime may not change for years. Or it can potentially change several times within one year especially in economically turbulent times.

Who determines the prime rate?

The prime rate is not set by the government. But it does closely follow another interest rate, which is set by the Federal Reserve: the federal funds rate.

The Fed sets and adjusts the federal funds rate to keep the US economy on an even keel between recession and over-expansion. When the economy slows down, the rate is lowered to spur economic growth. When the economy grows too fast, the rate gets raised to try and stave off inflation.

Commercial banks use the federal funds rate when charging each other for overnight loans. In turn, these banks use the same rate as the starting point in setting the prime rate for their best-qualified clients.

Commercial banks generally adjust the prime rate roughly three percentage points above the federal funds rate. However, some banks set their lending rates up to five percentage points higher.

What is The Wall Street Journal prime rate?

There actually is no single prime rate; each bank or financial institution sets its own, based on its own lending criteria. When you see a reference to "the prime rate," it usually reflects an average rate across financial institutions.

The most commonly cited average — the "official source," so to speak — comes from The Wall Street Journal, which regularly surveys 30 of the largest US banks and publishes a consensus prime based on their rates. The Journal reports this average prime rate daily, whether there are changes to it or not. It alters when three-quarters of these financial institutions adjust their rates.

What is the prime rate today?

As of this writing, the Journal's published average prime rate is 3.25%. It has been at 3.25% since March 15, 2020.

How does the prime rate affect you?

Only the largest, most stable corporations with sterling credit scores generally qualify for the prime rate. But there's a ripple effect. Personal loans, small business loans, credit cards, and mortgages all carry interest rates that are based on or tied to the prime rate.

If you take out a fixed-rate loan, it'll be based on what the prime currently is. If you have variable-rate debt, it'll fluctuate along with the prime.

In addition, fluctuations in the prime rate can reflect how tough or relaxed lenders' financing standards and requirements are. When the prime rate is low, it's easier to get a loan. When the prime rate is high, it often makes borrowing a lot more challenging.

What things does the prime rate affect?

Here's how the prime rate affects different types of everyday debt and loans. Of course, a variety of other factors affect your interest rate. The terms can be higher or lower based on the prime rate, plus your credit score, your risk profile, your type of loan, your location, and the length of time it will take you to repay.

Credit Cards

Most credit cards have variable interest rates set several percentage points above the prime: "prime plus 13.99%". As the prime rate changes, you will see the increase or the decrease in your card's annual percentage yield within a billing cycle or two.

Mortgages

The prime most directly affects adjustable-rate mortgages. As it fluctuates, so should your adjustable rate at the annual reset. The impact is greatest on shorter-term loans; if you have a 30-year mortgage, it might not move much when the prime decreases. But you may still take advantage by opting to refinance your mortgage at a lower rate instead.

Auto Loans

Auto loans closely track the prime, especially if car dealers are hungry for business. For example, with the current prime at 3.25%, a five-year auto loan is averaging 4.24% for a new vehicle; for a used car, around 5.08%.

The Financial Takeaway

Just as the federal funds rate serves as the basis for the prime rate, the prime serves as the starting point for most consumer banking products. While individuals rarely receive the prime, their personal and small business loans, credit card rates, and mortgages reflect the prime rate. If their interest rates are variable, they'll shift according to changes in the prime rate.

Although it is not an official interest rate — or even one single interest rate — the prime rate acts as a sort of harbinger for the state of the economy, reflecting how easy it is to borrow, whether the government is encouraging or discouraging spending, and how confident banks feel about loaning money.