What is the Prime Rate?

Prime rate is the term used to refer to a reference interest rate used by banks. The prime rate has historically been the rate banks offered to their most favorable borrowers. Banks would offer loans at the prime rate to mortgage borrowers with outstanding credit, or to businesses with great credit ratings, for instance.

The prime rate carries a lot of importance for consumers, as it is often used as a reference in calculating rates for specific types of consumer loans. It is frequently used in calculating the rates for adjustable rate mortgages (ARM), student loans and credit cards.

ARMs, for instance, will often have their rate set at one, two, or three percentage points above the prime rate. Many private student loans set their rates a prescribed rate (often called the margin or spread) above the prime rate. Most credit cards set their rate at any given time by adding a certain spread to the prime rate. A credit card company might offer a well-established customer with a good credit score a rate of prime plus 8%, and a borrower with shoddier credit history prime plus 15% or more.

But where does this rate come from?

Origins of the Prime Rate

While there is no central authority that fixes the prime rate, it is closely fixed to the federal funds rate. The federal funds rate is the rate at which banks loan each other funds from balances at the Federal Reserve.

Banks are required to have certain ratios of cash to liabilities at the close of each month. To maintain these ratios, banks frequently borrow from one another to keep their books solvent. The interest rate for such a loan is negotiated between the two banks. The weighted average of these rates across all banks is referred to as the federal funds effective rate.

As stated previously, the rate of interest for these loans is set by individual banks taking part in the loan. However, the Federal Open Market Commission (FOMC) does set the federal funds target rate. In practice, the effective rate does not vary much from the Fed’s target rate, largely because the Fed can use other methods to bring lending rates closer to its target rate. With this in mind, banks tend to keep their lending to one another at rates close to the target.

The prime, though not set by a central authority, tends to stay around 3 percentage points above the federal funds rate.

The Prime Rate and the Economy

Interest rates affect the economy in more ways than most people think about. When the fed raises its target rate, the economy will begin to slow down. This happens for a number of reasons.

Banks will slowly begin to lend less. Because rates are higher, homeowners will be able to borrow less. Borrowers with ARMs will suffer from higher payments and have fewer discretionary dollars to spend. Restrictions on home buying mean less demand for new homes, which means less demand for home-building supplies and home-building labor.

Because of higher interest rates, businesses will be able to borrow less money for new equipment and expansion. A prolonged period of high interest rates can often lead to recession. Often times, people in vulnerable positions or those who work in cyclical industries can find themselves laid off during such periods.

But on the bright side, high interest rates also mean slower inflation.

On the other hand, lowering interest rates often produces economic growth. Loan dollars are more available to businesses and home buyers. Looser lending creates more demand for both existing and new homes, and for equipment for businesses eager to expand. This is precisely what helped bring about the U.S. economic boom in the 80s, after a massive economic slump in the late seventies. The federal funds rate peaked at 20% late May of 1981. A fast drop to 9.5% in October of 1982 helped spur massive economic growth.

Neither the growth nor the slowed growth due to interest rate changes is immediate. Typically, these changes take around 12-18 months to take full affect in the larger economy.

The same cannot be said for the stock market, though. Upon hearing about a slightly higher rate, investors expecting slowed growth often pull dollars from the stock market, resulting in a drastic drop in prices. The converse is also true: a lowered federal rate often sends stock market values up quickly.

Many investors who use short-term strategies search the news for any indication about how the FOMC might move the target rate. If an investor correctly predicts an increase in rates and a drop in stock value, he or she can make a pretty penny in a carefully executed short sale. Investors correctly predicting a rise in rates and a drop in stock prices can sell off stocks at a temporary high.

What it Means for You

What does all this mean for you? The primary way that the prime rate affects most consumers is their mortgage and the value of their home. Buying a home during a period of high rates will mean that you’ll pay a larger amount for your mortgage, or that you’ll be able to borrow less.

Selling during times of high rates can be precarious, too. This happens because high rates lower the demand for homes, as homeowners are able to borrow less. This also means that you may find that the value of your home is not worth quite as much as you’d expected. This doesn’t necessarily make it a bad time to sell. That depends on a number of other variables. If you plan on buying a home in another area that also has depressed home prices, it could still be a good time to sell.

There are times when a high interest rate may be beneficial for you. As we said above, higher rates mean less inflation, which means your dollars can go farther.

If you were lucky enough to lock in a low interest rate on a mortgage and you aren’t facing risk of a lay-off because of a long period of high interest rates, you might find yourself with extra dollars that can still go far.

On the other hand, if you have any outstanding credit card balances, a rising prime rate can mean trouble. Take a high interest rate as a reason to pay those balances down! Remember, the rate you pay your credit card lender is usually prime plus a margin. That means that as the federal funds rate rises, your bank’s prime rate goes with it, and that means increased interest on your card balance!

Published or Updated: April 4, 2013
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

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