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The prime rate is the best interest rate that major banks extend to their borrowers with the best credit. Find out how the prime interest rate affects you.

The prime rate explained

The prime rate is offered to the most creditworthy customers.
igorstevanovic / Shutterstock
Banks allow their most creditworthy customers to borrow at the prime rate.

The prime rate is a key lending rate that's used to set many variable interest rates, such as the rates on credit cards.

Banks have kept the prime at 5.5% since December, when the Federal Reserve last raised interest rates.

Now that Fed policymakers have cut rates by one-quarter of one percentage point, banks are almost certain to respond with a similar reduction in the prime rate, to 5.25%.

Despite a common misunderstanding, changes in the prime are not dictated by the Fed, though the prime rate is closely tied to the federal funds rate. That's the benchmark interest rate that the Fed controls.

Each time the central bank gives the federal funds rate a nudge, the big banks almost immediately make a matching move with the prime.

Why the prime rate moves

Federal Reserve officials set their target for the federal funds rate based on how well the economy’s growing and the outlook for inflation.

Whenever the economy is booming in a way that could heat up inflation, the central bankers raise the federal funds rate to keep spending and prices under control. And the prime lending rate goes up, too.

The Fed tends to lower its interest rate in times of high unemployment, a sluggish economy or weak inflation. And that pushes down the prime.

So why have the central bankers cut rates now, with the stock market mowing down records and the economy still expanding? The Fed did it as "insurance" — to keep the good times going.

What the prime rate means for you

The prime rate has a direct impact on credit card rates.
Yulia Grigoryeva / Shutterstock
The prime has a direct impact on credit card rates.

If you've got credit cards (and who doesn't?) or a home equity line of credit, better known as a HELOC, you feel the movements in the prime rate most directly.

Rates on those products change in lockstep with the prime. In fact, the adjustable rate on a HELOC might be advertised as "prime plus 1%" or "prime plus one," for example.

That means the rate on a hypothetical home equity line will slip to 6.25% as the prime falls to 5.25%.

You can expect to pay lower interest on your plastic or your HELOC as soon as several weeks after any Fed rate hike.

The prime rate and other loans

Rates on auto loans, personal loans and some adjustable-rate mortgages also piggyback off the prime.

And while fixed mortgage rates don't necessarily follow the lead of the federal funds rate and the prime, they can be influenced by those benchmarks indirectly.

Mortgage rates already have dropped to the lowest levels in nearly three years in anticipation of a Fed rate cut.

Timing is crucial when you’re deciding to borrow money. If you’re in the market for a mortgage, an auto loan or a personal loan, you may want to latch onto a lower rate whenever you see one.