Prime Rate: What is It and Why Does It Matter?
Q: What exactly is the “prime rate?” How does it affect me as an individual?
A: It is the current interest rate that financial institutions in the U.S. charge their best customers. These customers have excellent credit and are eligible for this optimal rate. This is because their loans carry the lowest risk for their financial institutions.
The prime rate is also called the prime interest rate, prime lending rate, or simply prime. You may hear this term in the financial news or when reading up on loans and mortgages. That’s because this rate affects every level of the economy.
We have answers to all your questions below.
How is the prime rate determined?
Prime is based on another rate, which the Federal Reserve Board sets. It’s an interconnected system starting with the government and ultimately impacting each of us on some level.
The prime rate is determined in three steps:
- The Federal Reserve System, which is the central U.S. bank, sets the federal funds target rate. This is the interest rate it thinks is best for financial institutions to use when lending each other money.
- Financial institutions lend each other money to maintain their reserve requirements. They base the interest rates they charge each other on the federal funds target rate.
- The Wall Street Journal surveys the largest financial institutions in the country to determine the rate they are using. They then publish this rate as the prime rate. This number is generally three percent higher than the federal funds target rate.
The fed’s target rate, and consequently the prime rate, changes often. In fact, the Federal Open Market Committee, which sets the federal funds target rate, meets a minimum of eight times a year to discuss possibly changing the target rate.
The prime rate reached its peak of 8.25% in the second half of 2006 and then steadily decreased to a low of 3.25% at the start of 2009. It recently increased to 3.50% in March 2022. You can check out the changes in the prime rate at Federalreserve.gov.
How does it affect the average individual?
There are two ways that prime affects you.
First, it affects the interest rate on nearly every loan, including mortgages and credit cards. Financial institutions and large lenders base their interest rates on the prime rate, generally establishing their current rates at an amount that is higher than prime to cover their larger risk of default. If prime rises, the interest rates on your loans and adjustable-rate credit cards will rise as well.
Second, prime affects liquidity in the financial markets. When the rate is low, liquidity increases. This means funds are more readily available because loans are less expensive and easier to qualify for. This, in turn, generates a growing economy as businesses expand.
Conversely, when the prime rate is high, liquidity is low and loans are hard to come by, thus slowing the economy down.
Is the prime rate the only factor used to determine individual interest rates?
While it is the starting point that financial institutions and large lenders use in determining an interest rate for a loan, it is by no means the only factor they’ll consider.
Your credit score plays a vital role in the interest rate you pay for a large loan. The higher your score, the lower the interest rate you’ll earn. Keep your score high by using your cards responsibly and paying your credit card bills on time.
Here at United Texas Credit Union, we also consider your credit history and the general state of your finances when determining your interest rate on a loan. If we see that you’re moving on an upward trajectory and working toward paying down your debts, we’ll be more likely to grant you a favorable interest rate on any loan we offer.
Also, keep in mind that as an institution devoted to your success, we are always striving to help you achieve and maintain financial wellness. While your specific interest rate may vary due to personal circumstances, you’ll know you’re always getting the best possible terms here at United Texas Credit Union.
The prime rate is an important element in the overall state of the U.S. economy and in your personal finances as well. While you have no control over the rate’s rise and fall, you can do your part in keeping your interest rates low by maintaining a high credit score, living with financial responsibility, and taking advantage of the excellent rates on products offered at United Texas Credit Union.
Your Turn: How do you keep your credit score high and your interest rates low? Share your best tips with us in the comments.
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Sources:
https://www.investopedia.com/terms/p/primerate.asp