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By Michelle Huffman
If you’ve ever had a credit card, car loan or mortgage, your life has been impacted by the prime rate — even though many people don’t know what it is.
The prime rate is the interest rate banks offer their most creditworthy customers. It is the best rate the banks have to offer the most qualified customers, typically corporations.
The prime rate is largely determined by the federal funds rate. The federal funds rate is the interest rate banks charge other banks to borrow money overnight. Without getting too technical about it, banks must keep a certain percentage of their deposits with the Federal Reserve, the central bank of the U.S. On a day-to-day basis, some banks have too much money in deposits, and others come up short. So the banks regularly lend money to each other overnight so the short bank can balance its books and the overfull bank can make money.
So then how is the federal funds rate determined? The Federal Reserve, a.k.a. “the Fed,” has a committee called The Federal Open Market Committee (FOMC) that meets at least eight times a year, or about every six weeks, to set the federal funds rate based on economic indicators. It can’t force the banks to lend at that rate, but the rate is a target for the bank’s negotiated rates. The Fed can adjust the money supply to move interest rates closer to the federal funds rate.
Ultimately, the prime rate moves in parallel with the federal funds rate, and is generally set at about 3% over the federal rate.
You may frequently see The Wall Street Journal, or WSJ, Prime Rate, as a term in connection to the prime rate. So how does the Journal factor in? The Wall Street Journal surveys the 10 largest U.S. banks and publishes the average rate. When seven (or more) of those banks change their prime rate, the WSJ changes its published rate. Sometimes the rate stays static for years (like it did from 2008 to 2015) and sometimes it changes multiple times in a year (like it did in 2018).
Other banks will then base their interest rates on the WSJ rate, which, in turn, sets the rates for various consumer lending products, like mortgages, home equity loans, home equity lines of credit (HELOC), credit cards and auto loans.
Savvy consumers should pay attention to the WSJ prime rate because a change in the rate is often the precursor to a change in their interest rates. This is particularly pronounced for adjustable or variable rate products, such as a HELOC or a credit card — and keep in mind, if you have a variable rate credit card, the company doesn’t have to notify you of every rate change.
For example, if you have a variable rate credit card, your interest rate may be tied to the prime rate. Let’s say you’re charged a 13% interest rate plus the prime rate. If the prime rate is 3.5%, then you will be charged a 16.5% APR.
The prime rate also forms the basis for other lending products, such as mortgages. Though your individual credit profile elements — credit score, credit history, income and debt — may bear more weight in determining your interest rate, the prime rate dictates the best rate available, upon which other offered interest rates are based.
Keeping an eye on the prime rate will make you a better educated fiscal consumer and help you better understand your own financial obligations.
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