You may have heard the term “prime rate” thrown around, and moreover, might have noticed that it’s not quite the same as the interest rate you are being charged by your bank. The Wall Street Journal defines the prime rate as “The base rate on corporate loans posted by at least 75% of the nation’s 30 largest banks.” What does the rate charged corporate loan customers have to do with you, and how does the prime rate relate to the federal funds rate?
The prime rate is calculated based on the federal funds interest rate. The federal funds rate is set by the Federal Reserve. The prime rate is most often around three percentage points above the federal funds rate. The federal funds rate is the interest rate charged by banks to other banks for overnight loans required to fulfill federal funding regulations. The prime rate does change and adjust, albeit not frequently, often in tandem with the federal funds rate. Recently, the Federal Reserve lowered the federal funds rate, and consequently the prime rate dropped. The Wall Street Journal publishes the official prime rate and adjusts their figures when 23 out of the 30 largest banks change theirs.
The answer is surprisingly simple. Most interest rates charged to the average American customer, ranging from car loans to home loans, credit cards and other consumer debt are based on the prime rate. Many aspects of consumer life and consumer debt are controlled by the prime rate. If you have an adjustable rate mortgage, student loans, a variable interest home equity loan, or many credit cards, a change in the prime rate can mean a change in the amount of interest you accumulate during the financing period and even your monthly payments.
You may have seen interest rate calculations written as the prime rate plus a set percentage. This is quite common in variable rate financing of various sorts. In this case, a lower prime rate will drop your payments, while a higher one will increase them. This is often referred to as “prime plus” in your credit terms. If you are consider new financing, do keep in mind that while the most recent change in the prime rate was a distinct drop, the prime rate can, and has in recent years, increased substantially. If you prefer to avoid these changes, be sure to choose fixed rate financing that is not based on the “prime plus” equation.