Have you ever noticed your credit card rate inching upward? Or certain loan payments increasing from a rise in interest rates? Chances are that those shifts are the result of changes to the prime rate.
The “prime rate” may sound like financial jargon, but it plays a significant role for borrowers and savers alike. This figure sets the bar when lenders price loans, and it changes more often than you might think.
In this article, we’ll shed light on what the prime rate is, how it’s determined, and the impact it can have on your everyday finances.
What is the Prime Rate?
The prime rate is the interest rate credit unions and banks offer to their most creditworthy borrowers – typically those with excellent credit histories. But even if you’re not a top-tier borrower, the prime rate still affects you.
Many loans, such as credit cards, home equity loans, and mortgages, are based directly on the prime rate. When this figure goes up or down, your loan’s interest rate may follow, especially if it’s a variable-rate loan. That means your monthly payments could increase or decrease depending on what’s happening in the economy.
While lenders use the prime rate, they do not set it. The Federal Reserve, monetary policy, and overall economic trends influence the prime rate.
How is the Prime Rate Set?
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Part #1: The Federal Funds Rate
You’ve likely heard on the news or read headlines about the Federal Reserve adjusting interest rates. What the Fed is doing is changing the Federal Funds Rate – the rate that banks and credit unions charge when they lend money to each other overnight.
The Federal Reserve meets eight times per year to adjust this rate, and decisions are based on current economic trends. For example, the Fed may raise the Federal Funds Rate to help curb inflation or lower it to entice more borrowing and spending.
Once the Federal Reserve sets the Federal Funds Rate, the Wall Street Journal surveys the largest financial institutions in the country to determine the rate they are using. The calculation of the majority rate is then published as the prime rate.
As a general benchmark, the prime rate is usually around 3% higher than the Federal Funds Rate.
How Does the Prime Rate Affect Me?
The prime rate directly affects the cost of many loans and credit products. As a borrower, here is what you can expect when the rate shifts.
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When the Prime Rate Goes Up:
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Loan & credit card rates will increase.
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Monthly payments on variable-rate loans may increase.
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Borrowing becomes more expensive, leading to a decline in loan demand.
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Refinancing loans becomes less attractive due to higher rates.
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When the Prime Rate Goes Down:
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Loan & credit card rates will decrease.
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Monthly payments on variable-rate loans may decrease.
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Borrowing becomes more affordable, providing easier access for consumers.
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Market conditions provide more opportunities to lower loan rates by refinancing.
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How Changes in the Prime Rate Impact Specific Loans:
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Credit Cards: Most credit cards today have variable-interest rates based on the prime rate. If the prime rate increases or decreases, your credit card rate will follow suit.
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Mortgages: If you have a traditional fixed-rate mortgage, the prime rate will not affect your loan or monthly payments. However, if your loan is an adjustable-rate mortgage (ARM), changes in the prime rate will directly affect your mortgage rate and monthly payments.
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Home Equity Loans: For homeowners with a traditional home equity loan, your rates will generally be fixed and unchanged by fluctuations in the prime rate. However, homeowners with a home equity line of credit (HELOC) typically have rates tied to the prime rate, and payments can likewise fluctuate.
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Auto Loans: While car loan rates are generally not tied to the prime rate, changes can affect the broader lending market. For example, if the Federal Reserve raises rates to curb inflation, lenders will often raise all their loan rates in response – driving up rates for auto loans.
Example: See Prime Rate Changes in Action
Most lenders today offer credit cards that have variable interest rates, which are based on the prime rate. For example, you’ll often see rates advertised as 9.99% APR + Prime Rate.
IMPORTANT NOTE: Many people incorrectly assume the rate offered is 9.99% APR. It’s crucial when evaluating credit cards and their rates that you thoroughly understand the terms. More responsible lenders will advertise the rate as 9.99% APR + 7.50% (Prime Rate) = 17.49% APR (that’s a BIG difference!).
Using the rates above, the prime rate is 7.50%, and your credit card rate is 9.99% APR + Prime Rate. Your actual interest rate would be 17.49% APR.
Now, assume the Fed increases the Federal Funds Rate by 1%. The prime rate will likely follow suit, rising from 7.50% to 8.50%. Now, your credit card rate will become 18.49% APR. If rates were lowered instead by 1%, your rate would fall from 17.49% APR to 16.49% APR.
Historical Examples:
While the Federal Reserve meets eight times a year to evaluate rates, it doesn’t always change them. Again, increases and decreases are based on economic trends. However, these rates do fluctuate over time.
Here are a few examples of different prime rates over the years, and how they would impact our credit card example with rates at 9.99% APR + Prime Rate.
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December 19, 2024 – Prime Rate = 7.50%
Credit Card Rate = 9.99% APR + 7.50% = 17.49% APR
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March 16, 2020 – Prime Rate = 3.25%
Credit Card Rate = 9.99% APR + 3.25% = 13.24% APR
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January 4, 2001 – Prime Rate = 9.00%
Credit Card Rate = 9.99% APR + 9.00% = 18.99% APR
Using the Prime Rate to Your Advantage
Unfortunately, changes to the Federal Funds Rate and prime rate are largely out of the general population’s control. However, by understanding how these figures affect loan rates, you can make more informed financial decisions.
For example, if you’re considering purchasing a new home but the prime rate continues to rise, it might be smarter to hold off for a bit. If you can’t wait and need to purchase a home now, keep an eye on the prime rate over the next couple of years. Sudden drops could signal the perfect opportunity to refinance your mortgage into a lower-rate loan.
Additionally, when evaluating credit cards, you’ll better understand the true rate that you’re being charged. If you want to avoid fluctuating credit card rates altogether, consider a credit card that offers fixed interest rates instead.
We’re Here to Help!
The economy is constantly evolving, and the Federal Reserve strives to implement monetary policies that will benefit the U.S. population. Sometimes that involves lowering or raising the Federal Funds Rate – and, subsequently, the prime rate. With a basic understanding of how the prime rate affects your borrowing power, you can make wiser financial decisions.
If you have questions about your current loan rates or want to explore opportunities to refinance and switch your current loans to the credit union, we’re ready to help. Please stop by the Credit Union or call 410-908-7618 to schedule an appointment with our lending team.