Prime rate definition
The prime rate is a key lending rate used to set many variable interest rates, such as the rates on credit cards and home equity lines or credit, or HELOCs.
But more specifically, it's the rate that commercial banks offer to their most creditworthy customers — including corporations, and consumers with the highest credit scores.
Borrowers who are considered more likely to default — that is, not pay back a loan — get higher rates.
Technically, there is no single prime rate. Each bank sets its own, but they're generally all the same and move in lockstep with the Fed's favorite interest rate.
How do banks determine the prime rate?
The prime rate piggybacks off the federal funds rate, the interest rate that's one of the Federal Reserve's primary tools for nudging the economy. Banks normally take that rate and add 3 percentage points to get their prime.
The federal funds rate is the interest banks charge each other for overnight loans so they can meet their reserve requirements. Those are the amounts of money the Fed requires banks to have on hand at the end of each business day, partly to guard against bank failures.
The central bank doesn't exactly set the federal funds rate; it's ultimately decided by market supply-and-demand forces. But the Fed's policymaking panel — called the Federal Open Market Committee, or FOMC — establishes a target for the rate.
The current federal funds rate target is a range of 0% to 0.25%, which matches an all-time low established during the 2008-2009 financial crisis and Great Recession.
Why the prime lending rate moves
The prime rate goes up or down whenever the federal funds rate is adjusted. The members of the FOMC meet eight times a year to review the state of the economy and the outlook for inflation — and revisit their target for the federal funds rate.
The Fed has been given a dual mandate by Congress: to promote stable prices and maximum employment.
Though they plan to be a little more tolerant of inflation going forward, the central bankers have tended to raise the federal funds rate whenever spending and prices have gotten too hot. And the prime lending rate has gone up, too.
The Fed lowers its interest rate where there are trouble signs for the economy and employment, or in times of weak inflation. And that pulls down the prime.
More: Worried about the state of your portfolio? Get low-cost tips from a financial adviser at Facet Wealth.
What the prime interest rate has been doing
The prime rose from December 2016 through December 2018 as the federal funds rate was hiked eight times. Fed officials said they were trying to put interest rates more or less back to normal from the lows of the Great Recession and its aftermath.
In 2019, they cut rates three times amid signs the economy's growth was slowing. And this year, policymakers slashed the federal funds rate in two stages down to its current near-zero level, to try to protect the economy from the raging coronavirus and COVID-19 pandemic.
"The coronavirus outbreak has harmed communities and disrupted economic activity in many countries, including the United States. Global financial conditions have also been significantly affected," the Fed said.
Data released by the Federal Reserve has indicated officials believe the economic recovery from the coronavirus will be a slow one — which is why no rate moves are likely before 2024.
Federal Funds Rate vs. Prime Rate vs. Growth in Personal Loans
Banks set the prime rate, not the Federal Reserve, but the prime moves in sync with the Fed’s benchmark interest rate, the federal funds rate.
What is today's WSJ prime rate?
The Wall Street Journal (WSJ) publishes what's considered to be the definitive U.S. prime rate, which is determined through a survey.
As the Journal explains, its prime rate is "the base rate on corporate loans posted by at least 70% of the 10 largest U.S. banks."
Though the Wall Street Journal prime rate generally matches the prime rate posted by the big banks — again, normally the federal funds rate plus 3 points — it is the official prime rate that's used to set many other borrowing costs.
|This week||1 month ago||3 months ago||1 year ago|
|Federal Funds Rate (Current target range 0.00-0.25)||0.25||0.25||0.25||1.75|
|WSJ Prime Rate||3.25||3.25||3.25||4.75|
How does the prime rate affect me?
The prime rate directly impacts certain types of credit, namely loans with rates that are adjustable, not fixed. The prime — and the federal funds rate — influence other interest rates in a more roundabout way.
The prime rate and variable-rate loans
Rates on those products change in sync with the prime. The adjustable rate on a HELOC might be advertised as "prime plus 1%" or "prime plus one," for example.
The rate on that hypothetical home equity line would have dropped from 5.25% to 4.25% when the prime plummeted from 4.25% to 3.25%.
In similar fashion, a credit card might have an APR (annual percentage rate) described as "prime plus 11.49%" or "prime plus 9.99%."
You can expect to pay lower or higher interest on your plastic or your HELOC within weeks after a change is made in the prime rate.
The prime rate and other loans
Rates on auto loans are often tied to the prime rate, too, and many adjustable-rate mortgages, or ARMS, adjust in tune with the prime.
The interest on ARMs is fixed for the first several years, and then it moves up or down along with a benchmark interest rate. A common adjustable-rate mortgage is the 5/1 ARM, with a rate that's fixed for five (5) years and can adjust every (1) year after that.
Frequently the yardstick for ARM rates, during their adjustable period, is the prime.
The rates on personal loans and popular fixed-rate mortgages do not dovetail off the prime rate and the federal funds rate, but there is an indirect effect on what borrowers pay.
As the Fed has cut its rate to near zero and created a climate for very low interest rates, mortgage rates have dropped to the lowest levels in history.
But long-term mortgage rates don't always move in the same direction as the prime. For example, 30-year mortgage rates fell between December 2016 and December 2017 — even as the prime rate rose from 3.75% to 4.50%.
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.