Prime Rate And What You Need To Know

What Is the Prime Rate and How Did it Come About?

The prime rate is a common term that you may hear when applying for a loan or credit card. It acts as a benchmark for determining interest rates, mostly for short-term and medium-term loans.

Commercial banks typically charge the prime lending rate to customers with excellent credit while those with a higher risk of defaulting receive higher rates.

Here is a closer look at the prime rate, including where it came from and what it means for you.

Where Did the Prime Lending Rate Come From?

A prime rate is a base interest rate that banks use as an index when calculating rates for new loans. Other names for this rate include the prime lending rate, prime interest rate, or the prime.

Since the 1950s, U.S. banks have based their prime rates on the federal funds target rate (FFTR).

A committee within the U.S. Federal Reserve system is responsible for adjusting the FFTR. The Federal Open Market Committee (FOMC) meets every six weeks to vote on changing the FFTR.

The committee sets a target for the FFTR based on the U.S. economy. When the economy’s strong, the committee typically raises the federal rate. During recessions and periods of high unemployment or weak inflation, the committee tends to lower the rate.

Banks use the federal funds rate when charging each other for overnight loans to fulfill the reserve each night. They then add a percentage when charging customers, creating the prime rate.

Since 1994, U.S. banks have set prime rates based on the FFTR plus 3%. For example, as of the first quarter of 2019, the U.S. FFTR is 2.5% and the average prime interest rate is 5.5%.

When the FFTR changes, the top U.S. commercial banks change their base rates. Most other FDIC-insured banks follow suit within several days.

Banks are free to set their own rates. However, they typically use the same base rate to continue offering competitive, consistent loan products. As most banks use the same rate, people also call it the nation’s prime rate.

Banks Use the Prime Lending Rate as an Index

When banks advertise interest rates for various loan products, they often express the rate as a percentage above or below the prime lending rate. For example, you may see a home equity line of credit offer advertised as “prime plus one”.

The prime lending rate also provides an index for calculating rate changes to variable rate short-term loans and adjustable-rate mortgages (ARM). With these loans, the monthly payments may change when the FFTR increases or decreases as banks then adjust their prime lending rate.

You may also see the prime mentioned when reviewing the rates for credit cards and other lines of credit with variable interest rates. Banks use the prime interest rate plus a fixed value called the margin or spread.

The Prime Lending Rate Peaked in 1980

When banks first started using the FFTR to set prime lending rates in the 1950s, the national rate was between 3% and 3.5%. It gradually increased through the 1950s and 1960s before experiencing a reduction in the early 1970s due to economic hard times.

By April 1974, the U.S. prime lending rate had reached 10% and peaked at 21.5% in December 1980. Over the next two decades, rates fluctuated between 6% and 10%.

Rates reached their lowest level of the new millennium in 2008 during the financial recession. In the years since the recession, the rates have slowly increased, reaching 5.5% in December 2018.

What Types of Loans Depend on the Prime Rate?

The prime does not directly affect fixed mortgage interest rates or other types of loans with fixed interest. It mostly impacts the monthly payments for credit cards and loans with variable interest rates.

With the following types of loans, your lender will likely increase or decrease interest charges based on the federal rate:

• Adjustable-rate mortgages
• Interest-only mortgages
• Home equity lines of credit (HELOC)
• Short-term loans with variable interest
• Student loans
• Automobile loans
• Credit cards

As the prime lending rate fluctuates based on the economy, it provides a useful index for commercial and consumer borrowing. For those same reasons, it does not provide an effective index for long-term loans such as fixed-rate mortgages.

While the national rate does not directly impact fixed mortgages, it does influence the rates that lenders offer. When the prime lending rate increases, lenders tend to increase interest rates for new home loans.

How Does the Prime Lending Rate Affect You?

If you obtain a loan with variable rate interest or a credit card, you feel the effect of changes to the prime rate through higher interest charges.

Those with the best credit and least risk of defaulting on the loan get the prime rate. Compared to consumers, commercial borrowers are more likely to get the prime lending rate.

When you apply for a loan or credit card, the lender analyzes your credit score, income, and other factors to determine your risk. Banks offset potential risk with higher interest rates. As credit cards carry the most risk, they have the highest rates.

While the prime lending rate is typically 3% higher compared to the Fed’s rate, most borrowers receive a higher rate. The average credit card interest rate is about 19.24% while the average rate on a short-term unsecured loan is between 10% and 28%.

The spread, or margin, is the difference between the prime lending rate and the rate charged. With a variable interest rate, the spread remains the same, allowing your interest to go up or down with the prime.

Banks calculate interest charges each month for your bill so your monthly payments can change when the prime changes.

How Do You Find the Latest Prime Interest Rate?

No matter where you go for a loan, your lender likely sets its prime based on the federal fund rate. In fact, almost every bank and lending institution in the U.S. banking system uses the federal rate to set their prime interest rates.

While almost every bank uses the federal rate, it may take several days for most of the banks in the nation to adjust their primes. The Wall Street Journal (WSJ) publishes the current rate when the largest banks change their rates.

Prior to 2008, the WSJ published rates when 23 of the top 30 U.S. banks changed their rates. The publication now releases the rates when 70% to 75% of the top ten financial institutions in the country change.

Besides the WSJ, you can find the prime listed on financial news sites or by checking with your lender. Many financial institutions list the current prime lending rate on their websites.

If you struggle to find the rate through any of these sources, simply search for “what’s the current prime rate?”.

Summary

The Federal Reserve does not regulate the prime lending rate, but banks base their prime rates on the current federal fund rate. The Federal rate fluctuates depending on economic signals such as unemployment, inflation, and the financial market.

When the Feds increase the federal rate, banks increase their rates. Your interest rates also increase, resulting in higher payments.

You also typically find higher interest rates for new offers when the prime lending rate increases.

Whether you have a variable interest loan or plan on obtaining a new loan, paying attention to the latest prime may help you save on interest.

A financial advisor should be able to help with this too.

The post Prime Rate And What You Need To Know appeared first on Wealth And Finance.

source https://www.wealthandfinance.net/prime-rate-and-what-you-need-to-know/