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- The prime rate is the interest rate that banks charge their most creditworthy clients, usually banks or extremely wealthy individuals.
- Though not set by the government, the prime rate runs about 3% above the Federal Reserve's federal funds rate.
- Commercial banks use the prime as a basis for the interest they charge on consumer loans, credit cards, and mortgages.
Also known as the prime lending rate or simply the prime, the prime rate is the best possible interest rate that banks will give their customers. Even with your excellent credit score, you're not getting the prime rate. That's reserved for the most creditworthy, low-risk corporate customers or high net worth individuals. Think blue-chip stock companies or the likes of Warren Buffett.
But while the prime does not directly affect most consumers, it does provide the benchmark for many consumer and small business loans. It also affects other types of everyday debt, like credit cards, mortgages, and home equity lines of credit.
What is the prime rate?
The prime rate is an interest rate charged on loans. Much like any other interest rate, the prime exists to compensate the lender for the multiple risks they expose themselves to when extending credit to clients. What separates the prime rate from other interest rates is who qualifies for it.
Only stable businesses with the highest credit ratings qualify for the prime rate, as they're the ones that pose the least risk of defaulting on their loans. As the name "prime" implies, it tends to be the best — that is, the lowest — interest rate the financial institution charges.
Although it's a variable or floating, interest rate, the prime does not change at regular intervals. Rather, banks adjust it according to the shifts in the economy and the business cycle. The prime may not change for years. Or it can potentially change several times within one year especially in economically turbulent times.
Who determines the prime rate?
Prime rates are not set by the government. But they do closely follow another interest rate, which is set by the Federal Reserve: the federal funds rate. The Federal Open Market Committee recalculates this rate eight times a year or roughly every six weeks, based on the market conditions at the time.
The Fed sets and adjusts the federal funds rate to keep the US economy on an even keel between recession and over-expansion. When economic growth slows down or starts to recede, the rate is lowered to spur economic growth. When the economy grows too fast, the Fed raises the rate to try and stave off inflation.
Commercial banks use the federal funds rate when charging each other for overnight loans. In turn, these banks use the same rate as the starting point in setting the prime rate for their best-qualified clients.
Banks generally adjust the prime rate roughly 3% above the federal funds rate. However, some banks set their lending rates up to five percentage points higher.
What is The Wall Street Journal prime rate?
While many banks set their prime rate according to the federal funds rate, there's no single prime rate. When you see a reference to "the prime rate," it usually reflects an average rate across financial institutions.
That said, the Wall Street Journal's prime rate is one of the most commonly cited averages — the "official source," so to speak. The Wall Street Journal surveys 10 of the largest US banks and publishes a consensus prime based on their rates. The Journal reports this average prime rate on a daily basis even if the rate hasn't changed. It alters when three-quarters of these financial institutions adjust their rates.
How does the prime rate affect you?
Only the largest, most stable corporations with sterling credit scores generally qualify for the prime rate. However, changes in the prime rate ripple out to regular borrowers. The prime rate will affect the interest rates on personal loans, small business loans, credit cards, and mortgages, which are further affected by the borrower's credit history.
If you take out a fixed-rate loan, your interest will be based on what the prime is at the start of the loan. If you have variable-rate debt, it'll fluctuate along with the prime.
Fluctuations in the prime rate can reflect how tough or relaxed lenders' financing standards and requirements are. When the prime rate is low, it's easier to get a loan. When the prime rate is high, it often makes borrowing a lot more challenging. Because they're based on the federal funds rate, prime rates also reflect the state of the economy. During times of recession, prime rates are generally lower, hitting 3.25% during the Great Recession.
What things does the prime rate affect?
Here's how the prime rate affects different types of everyday debt and loans. Of course, a variety of other factors affect your interest rate. The terms can be higher or lower based on the prime rate, plus your credit score, your risk profile, your type of loan, your location, and the length of time it will take you to repay.
Credit Cards
Most credit cards have variable interest rates set several percentage points above the prime: "prime plus 13.99%." As the prime rate changes, you will see a corresponding increase or decrease in your card's annual percentage yield (APR) within a billing cycle or two.
Mortgages
The prime most directly affects adjustable-rate mortgages. As it fluctuates, so should your adjustable rate at the annual reset. The impact is greatest on shorter-term loans; if you have a 30-year mortgage, it might not move much when the prime decreases. But you may still take advantage by opting to refinance your mortgage at a lower rate instead.
Auto Loans
Auto loans closely correlate with the prime, especially if car dealers are hungry for business. With the current prime at 4%, a 60-month auto loan is averaging 4.03% for a new vehicle; for a used car, around 4.17%.
The bottom line
Just as the federal funds rate serves as the basis for the prime rate, the prime serves as the starting point for most consumer banking products. While individuals rarely receive the prime, their personal and small business loans, credit card rates, and mortgages reflect the prime rate. If their interest rates are variable, they'll shift according to changes in the prime rate.
Although it is not an official interest rate — or even one single interest rate — the prime rate acts as a sort of harbinger for the state of the economy, reflecting how easy it is to borrow, whether the government is encouraging or discouraging spending, and how confident banks feel about loaning money.