If you’ve ever taken out a loan for anything, you may think that interest rates are randomly established. But typically, it’s anything but random. Consumer prices are based on the prime rate of a bank.
What is A Prime Rate?
Banks’ prime interest rate for customers with the best credit, often big companies, is known as the prime rate. Based on a study of the competition and the amount of margin each institution feels comfortable accepting, they each choose their own prime rate.
It usually closely mirrors the Federal Reserve‘s federal funds rate, which is set. To ensure they have enough cash to cover all of their depositors’ demands, banks lend money to other banks at this rate during an overnight period. Occasionally, a loan’s terms will specifically include the prime interest rate. A line of credit, adjustable-rate mortgage (ARM), or other loans, for instance, can have a variable interest rate of “Prime plus 3”. This implies that your loan’s interest rate will fluctuate with the prime rate. Your loan’s interest rate will be 6.25% (“Prime plus 3”) if the prime interest rate is 3.25%.
Because it might change based on market circumstances at any given time, the prime rate is often not specified in the contract when it is referenced. In other cases, the prime rate might not be mentioned directly in the interest rate for a loan, but it still influences the interest rate of almost every loan available.
How is The Prime Rate Determined?
The Federal Reserve Board sets a different rate based on the prime rate. It’s a complex system that starts with the government and ultimately has some effect on every one of us.
Three stages are needed to determine the prime rate:
- The federal funds’ target rate – the interest rate that financial institutions should use when borrowing money from one another – is determined by the Federal Reserve System, which serves as the country’s central bank.
- Financial institutions base the interest rates they charge on one another when they lend money to one another to maintain their reserve requirements on the federal funds’ target rate.
- The Wall Street Journal determines the prime rate through surveys of the biggest financial institutions in the country. Typically, this number is 3% higher than the federal funds’ target rate.
The prime rate often fluctuates along with the fed’s target rate. The Federal Open Market Committee, which determines the federal funds’ target rate, really meets at least eight times a year to discuss potential target rate changes.
The Prime Rate Effects
The prime rate impacts you in two different ways.
First, the prime rate impacts the interest rates on almost all loans, including credit cards and mortgages. Large lenders and financial institutions will base their interest rates on the prime rate, often setting their current rates at a level above prime to account for their increased default risk. The interest rates on your loans and credit cards with adjustable rates will also increase if the prime rate does too.
Second, the prime rate has an impact on the liquidity of the financial markets. Liquidity rises as the rate declines. Because loans are more affordable and simpler to qualify for, funds are therefore more easily accessible. As a result, the economy grows as companies expand.
In contrast, poor liquidity and difficult access to loans occur when the prime rate is high, slowing the economy.
Takeaways
- Banks’ prime interest rate for customers with the best credit, often big companies, is known as the prime rate.
- The contract’s prime rate is often not specified when referenced.
- A loan’s terms will specifically include the prime interest rate.
- The prime rate impacts the interest rates on almost all loans, including credit cards and mortgages.
- The prime rate has an impact on the liquidity of the financial markets.
