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The prime rate is one of the main factors used by banks to determine interest rates on loans. If you’re looking for a new variable rate mortgage or personal loan, understanding the prime rate and how it works can give you a better idea of how much you’ll pay and when is the best time to get a loan.
Definition of prime rate
The prime rate is the interest rate that banks charge their best customers for loans.
“The best in this sense are the borrowers with the lowest risk of default,” says Jeanette Garretty, chief economist and managing director of Robertson Stephens, a wealth management firm in San Francisco. This is usually the lowest interest rate that banks charge and is used as a benchmark for determining interest rates for other products, such as lines of credit, credit cards, and small business loans.
But the prime rate is just one factor that determines how much you’ll pay for the loans. Banks also consider your creditworthiness – the more likely you are to repay them, the lower the rate they would charge and vice versa.
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Who gets the prime rate?
Banks generally charge the prime rate only to large corporate customers with ample financial resources. This is because they have more money and assets to repay the loans. Since individual consumers do not have the same resources, banks generally charge them the prime rate plus a surcharge depending on the type of product they want. A credit card rate could be prime plus 10%, for example.
At the other end of the spectrum, a bank’s best borrowers may be able to negotiate an interest rate below prime. This type of trading occurred more frequently in the 1980s, Garretty notes, when interest rates were much higher. Lenders would try to attract prime borrowers by offering interest rates below prime.
What is the impact of the federal funds rate on the prime rate?
The federal funds rate is an interest rate range set by the Federal Reserve. The federal funds rate is the Fed’s recommendation for what banks should charge when lending money to each other overnight to meet reserve requirements.
“There’s a rule of thumb that the prime rate is ‘federal funds plus 3,'” Garretty explains. day.”
The prime rate only moves when the fed funds rate moves. “This is different from other rates (LIBOR, Treasuries), which move daily/weekly based on short-term financial market conditions (supply and demand),” says Garretty.
Once a bank changes its prime rate to reflect the new federal funds rate, it will then begin to adjust the rates of many of its other lending products in the same direction. And when the federal funds rate and the prime rate go down, other rates go down as well, making it cheaper to borrow.
Note that some lending products, like fixed rate mortgages and some student loans, are based on metrics like SOFR and are less tied to the movement of the prime rate.
What is the current prime rate?
As of February 8, 2022, the current prime rate is 3.25% in the United States, according to the Wall Street Journal Currency Rates Chart, which lists the most common prime rates charged in the United States and other countries by averaging the prime rate. from the 10 largest banks in each country.
The fed funds rate is currently 0.00% to 0.25%, so with that in mind, you can see how the rule of thumb of “federal funds plus 3” plays out: 3 + 0.25% = 3.25%.
Each bank has the option of setting its own prime rate. Most are based on the national average listed under the WSJ prime rate, but some might charge more or less depending on their goals.
Prime rate history
To give you an idea of how the prime rate changes and how often, here is an overview of the changes to the prime rate over the past few years:
The 10 Most Recent Prime Rate Changes
As you can see from the chart, as well as the longer term chart below, the prime rate is at historic lows today. It can’t fall any further because the fed funds rate is as low as possible without going negative.
“The last time rates were this low was during the financial crisis, when prime rates were also 3.25% from December 2008,” says Daniel Milan, managing partner of Cornerstone Financial Services at Southfield. , Michigan.
“Rates started rising around 2015 and continued to rise until March 2020 due to Covid-19. If you go back further in history, you have never seen rates as low as you would often see them in the mid single digits or even the low double digits, especially in the 80s and 90s,” he says.
What is the impact of the prime rate on you?
The prime rate sets the baseline for a variety of bank loans. When the prime rate increases, the cost of accessing small business loans, lines of credit, car loans, certain mortgages and credit card interest rates also increase. Since the current prime rate is at a historic low, it costs less to borrow than in the past.
The prime rate is also important if you have variable interest rate debt, where the bank can change your rate. This includes credit cards as well as adjustable rate mortgages, home equity loans, personal loans and adjustable rate student loans. If the prime rate goes up, the bank could end up charging you a higher interest rate, so your monthly payment on variable debt would go up.
“Decisions made by a bank’s asset and liability committee will ultimately determine where these other rates settle,” says Garretty. They could also consider their business strategies. For example, if one bank wants more credit card business on its books while another does not, it will offer different credit card rates, even though it is working with the same prime rate.
Therefore, the impact of a rise in prime rates may not be immediately obvious. However, over time, the prime rate pushes consumer rates in the same direction. By keeping an eye on prime rate trends, you can get an idea of the cost of borrowing and can plan for any changes.