What is the Prime Rate? How it Impacts the Interest You Pay on Loans and Credit Cards

Many food connoisseurs have long esteemed prime rib as one of the most prized cuts of beef. That must be why hearing the words “prime rate” has always made me a little hungry. Noting the similarity in sounds between “prime rate” and “prime rib,” my mind makes a link between the two. But that’s not where the similarities between the terms end.

Similar to prime rib, you can think of the prime rate as a leader in its field. Just like consumers, large corporations need loans sometimes, too. As prime rib is often a food reserved for honored guests, commercial banks charge the prime rate when extending credit to their best customers.

The prime rate is the interest rate commercial banks charge when they lend to their most creditworthy borrowers, which are usually corporations. 

So let’s jump into where the prime rate comes from and how it can impact you and your finances. I’ve researched all the juicy details about the prime rate and will serve them up to you in the sections below.

The prime rate is multifaceted and complex, and its impact is felt by businesses, consumers, and the overall economy.

Determining the Prime Rate

The Federal Reserve Board meets eight times per year to discuss and potentially adjust the federal funds rate, which is the rate banks charge one another for short-term loans that help them comply with legislation related to their cash reserves. 

Though the Federal Reserve doesn’t set the prime rate, it impacts it — banks use the federal funds rate as a starting point to determine the prime rate.

Want to wow some of your less financially savvy friends at dinner tonight? Tell them you can calculate the prime rate in your head. 

The most common calculation of the prime rate simply adds three percentage points to the federal funds rate. 

So if you know the federal funds rate, some basic math will get you to the prime rate. But don’t worry if the federal funds rate isn’t something you’ve memorized. Many publications, including the Wall Street Journal, publish the prime rate regularly.

Though banks each set their own prime rates, the prime rate the Wall Street Journal publishes is as close to an “official” prime rate as you’ll find.

According to disclosures on its website, the Wall Street Journal bases its U.S. prime rate on corporate loans offered by a minimum of 70% of the 10 largest banks in the country.

The Prime Rate’s Role in the Economy

You may be wondering how the prime rate affects you. For starters, it plays a major role in the interest rates you’re offered when you apply for credit cards and loans. I’ll take a deeper dive into that a little later, but the prime rate’s impact extends beyond lending products to affect the entire economy.

Businesses use lending solutions to finance their expansion into new markets and fund research and development efforts that help generate new products. If the prime rate increases, businesses might think twice about borrowing money, which means their plans for growth might be placed on the back burner, at least temporarily.

Higher prime rates can lead to a tighter job market. When businesses aren’t growing, they may not have as much of a demand for their workforce as they did during more prosperous periods. 

This is why some people view the Federal Reserve as a puppeteer that can control the economy and rates of inflation. When the Federal Reserve determines that inflation is above healthy levels, it can raise the federal funds rate to discourage borrowing and, subsequently, hinder economic growth.

Conversely, the Federal Reserve can lower the rate to entice borrowing and spur economic activity.

The prime rate also impacts savers and investors. If the rate increases, banks often offer more attractive savings rates to boost the amount of deposits they hold. When the prime rate decreases, you’ll find that most banks offer less attractive rates on their savings vehicles.

Though it’s not an exact science, fluctuations in the prime rate can impact the investing arena as well. Like all shoppers, investors search for good deals. When they estimate that savings rates will outperform investments over a certain time period, they may shift their money out of the securities markets and into savings products.

If enough investors or notable names in investing move their money out of stocks, it can have a ripple effect that leads to more selloffs and causes broader declines across market indexes.

When it comes to investing, many people choose to buy and hold their investments for years or even decades. But those looking for short-term opportunities in the markets should keep an eye on the prime rate to better gauge potential changes in security prices.

Factors That Influence the Prime Rate

So far, I’ve focused on how the Federal Reserve’s practices can affect the prime rate, but banks may adjust the prime rate in response to a number of other factors, including:

• Economic Indicators: If scientists announced that eating lemons each day could substantially prolong your life, you’d probably see the costs of lemons soar as people ignored their taste buds and started buying them in bulk. Though we don’t always think of loans as products, but they aren’t immune to the forces of supply and demand. A strong economy can lead to a greater demand for lending solutions, which can cause a bank to raise its prime rate. On the other hand, weaker economic times can motivate a bank to lower its prime rate to attract more borrowing activity.
• Bank Decisions: Banks don’t operate in a vacuum — they have competitors like any other business that isn’t a monopoly. Banks may raise their prime rates, or lower them, to attract more customers and best their competitors.
• Regulations: Banking is a highly regulated industry, which means that banks have to maintain certain depository levels and follow lending ordinances to comply with industry rules. Sometimes, a bank’s compliance efforts can cause them to shift their prime rate. For example, a bank that needs to raise capital may increase its prime rate to attract depositors. 

While the prime rate isn’t solely determined by these factors, they play a pretty major role. 

Money doesn’t grow on trees. If it did, loggers might not be so quick to chop down large swaths of the rainforest without giving it a second thought. 

Most of us need to use loans and credit products at times to help us get to where we want to be in life. Lending products can help us pay for college, finance vacations, or purchase our dream home. If you’ve taken out a loan or opened a credit card before, then you’ve likely owned a product that the prime rate has affected. 

Let’s set our deforestation concerns aside and see how.

Variable-Rate Loans

With a fixed-rate loan, your interest rate remains constant over the life of the loan. That means that changes to the prime rate won’t directly impact your loan’s rate. However, variable-rate loans feature interest rates that are tied to another rate, such as the prime rate.

Personal loans, including auto loans, home equity lines of credit (HELOCs), and adjustable-rate mortgages (ARMs), often have variable rates. 

Borrowers with these types of variable-rate loans need to make sure they’re prepared for prime rate increases, which can cause the interest rates on their products to go up and their monthly payments to increase.

If economic experts expect the Federal Reserve to raise the federal funds rate in the near future, beware of the domino effect on the prime rate and your product’s interest rate. When you’re deciding between a fixed-rate and variable-rate loan, examine your finances to make certain that pursuing a variable-rate loan will be in your best interest if the federal funds rate increases.

Credit Cards and the Prime Rate

Credit cards, those small pieces of plastic that save us from the papercuts that can occur when toting around stacks of paper currency, have rates that are often tied to the prime rate. For instance, a typical credit card’s interest rate is the prime rate plus another percentage. Check your card’s disclosures to understand how your card issuer calculates rates.

Of course, cardholders who pay off their balances in full each month don’t have to worry too much about credit card interest rates. But most of us miss a monthly payment every once in a while.

Cardholders should be prepared for hikes in their card’s interest rate when the prime rate increases. Conversely, you might experience a drop in your card’s interest rates when the prime rate plummets.

Life would be a lot easier if crystal balls worked. Then again, what fun would it be if we all knew the outcome of every sporting event and national election before they took place?

The good news about changes to the prime rate is that they’re often signaled well in advance of actually occurring. That allows borrowers to brace their finances for the impacts of a potential prime rate increase or decrease.

Monitor the Federal Reserve

Even if the Federal Reserve doesn’t decide to change the federal funds rate during one of its meetings, comments from its Chairman can signal future updates to the rate.

That’s one of the reasons why the stock market can swing so wildly during the course of public commentary by the Federal Reserve’s Chairman. 

You can watch the Fed’s press conferences online and read statements it releases to stay informed about pending changes to the prime rate. Doing so can help you prepare yourself for changes to financial products you own or are considering pursuing.

Read Financial News and Seek Out Resources

Studying Federal Reserve commentary and combing through its statements may not be your cup of tea. Actually, having some tea or your favorite caffeinated drink on hand may be a good idea if you’re planning for a marathon viewing of Fed press conferences.

Fortunately, news sources cover the Federal Reserve closely because they know how influential its actions are to the U.S. and global economic concerns, as well as the American taxpayer’s wallet.

Seek out a trusted news source that provides up-to-date reports on the Federal Reserve’s plans and other factors that can influence the prime rate. And familiarize yourself with the financial terms and trends that news outlets refer to when covering stories about the prime rate. 

BadCredit.org is a helpful resource to turn to when you need to increase your knowledge of financial terms and how they can affect your bottom line.

Lending products can help make our financial dreams come true, but be mindful of a product’s interest rate when shopping for a new loan or credit card. When you’re considering applying for a variable-rate solution, be sure to take note of how the lender derives the product’s interest rate.

The prime rate can impact how much interest you’ll owe a lender, but if you understand that and how prime rate changes can affect you, you’ll be one step closer to taking charge of your financial future.

So don’t hate the prime rate. It plays a big role in the economy as a whole. Speaking of which, I think I’ll have a dinner roll with my prime rib this evening.