What Is Prime Rate?

With the number of times the Fed has increased interest rates over the last few years, you have probably heard the term prime rate. But, what is the prime rate? And, how does it work?

At its core, the prime rate is an interest rate banks use to set their own rates for the financial products they offer. Read on to learn how the current prime rate can impact you and why you'll want to pay attention to interest rate shifts over time.

Key Takeaways

• The prime rate is directly correlated to the federal funds rate, which is set by the Federal Reserve.
• Note that the prime rate can immediately impact variable rate loans and credit cards, whose rates fluctuate up and down based on movements of the federal funds rate and prime rate.
• If you already have a fixed-rate loan, you don't have to worry about movements of the prime rate impacting your monthly payment.

What Is the Prime Rate?

The Board of Governors of the Federal Reserve System offers the following prime rate definition: 

The prime rate is an interest rate determined by individual banks.

The Fed goes on to say the prime rate is used as a reference rate or base rate that is used to determine the rates on credit cards and loans. 

That said, you shouldn't confuse the prime rate with the federal funds rate, as these two rates are different even though they impact one another in a major way. Generally speaking, the federal funds rate (the rate banks charge each other for lending money) is set by the Federal Reserve, and this rate is ultimately used to determine movements (up or down) of the prime rate.

How Is the Prime Rate Used?

Because the prime rate is used as a reference rate or "base rate," banks begin with the prime rate and set their own interest rates from there. As an example, a bank or lending institution might use the prime rate as a basis to determine their own rates, then add another 3% to the prime rate for their financial products.

This means that:

• Rising rates: When the prime rate goes up, the interest rate on financial products with variable rates (i.e. credit cards and variable rate loans) will also increase.
• Drops in the prime rate: When the prime rate is lowered, financial products with variable interest rates will see a rate drop.
• Potential for no impact: Fixed rate loan products can have higher interest rates for new borrowers after the prime rate goes up, yet consumers who already borrowed money with a fixed-rate product won't see their rate or payment change.

How Often Does the Prime Rate Change?

If you're wondering how often the current prime rate could change, you should know there are no hard and fast rules. Generally speaking, the Federal Reserve meets around six times each year to discuss the federal funds rate and potential changes that should come into play.

During these meetings:

• Rate movements are discussed: The Fed can decide to decrease or increase the federal funds rate (thus impacting the prime rate).
• Economic climate is discussed: These decisions are typically made based on current economic conditions, either good or bad.
• Additional meetings may be added to the schedule: The Fed can decide to meet more than six times per year in order to increase or decrease rates to combat inflation, economic stress, or both.

Because the prime rate can change many times throughout a year, and this change impacts the interest rates all of us pay, it's crucial to know the current prime rate and keep an eye on where this rate goes over time.

What Does a Change in the Prime Rate Indicate?

A change in the federal funds rate and prime rate can indicate any number of situations noted by the Federal Reserve. However, the impetus for the Fed to alter rates is not the same each time it happens. 

Here are some examples of conditions that have caused the Fed to increase or decrease rates over time:

• Employment issues: When the federal funds rate is lower and businesses can borrow more affordably, they tend to hire and grow at a faster rate. Thus, the Federal Reserve may enact a lower rate in order to promote hiring and expansion.
• Encouraging economic growth: When the federal funds rate and prime rate are low, this encourages borrowing, spending and other economic activities among consumers. Therefore, the Fed may be encouraged to lower rates when credit is tight and liquidity becomes a problem.
• Inflation worries: Over the course of 2022 and 2023, the Fed has increased the federal funds rate multiple times in order to combat record inflation. In fact, the Fed just announced its newest rate increase on May 3, 2023 with the stated goal of achieving "maximum employment and inflation at the rate of 2 percent over the longer run."

Why Does the Prime Rate Matter?

The prime rate matters because it directly impacts how much we pay to borrow money. We say this because the prime rate is used to determine credit card interest rates, rates for small business loans, equipment financing loans, and more.

When interest rates are higher, borrowing money becomes more expensive.

The impacts of a higher (or lower) prime rate can be substantial. Consider these examples that show the impact of the Fed increasing the current prime rate over the last few years.

• Surging credit card interest rates: Where average credit card interest rates for accounts assessed interest were at 16.04% in 2018 according to the Fed, the average rate on account assessed interest as of February 2023 came in at 20.92%.
• Higher personal loan rates: The average interest rate on a 24-month personal loan came in at 10.32% in 2018, but increased to 11.48% as of February 2023.
• Higher mortgage rates: Where the average borrower taking out a mortgage paid around 4.40% on a 30-year, fixed-rate home loan in 2018, today's borrowers are paying an average of 6.43% as of April 2023.

Who Qualifies for the Prime Rate?

The prime rate is only reserved for borrowers with good credit or excellent credit, which are also consumers who pose the least amount of risk when it comes to default. 

History of the Prime Rate

The prime rate dates back to the 1940s, although the way the prime rate is set and used has changed with market conditions and banking needs over time. Currently, many banks and lenders base their interest rates on the  WSJ Prime Rate, which is calculated by the Wall Street Journal based on the rates of 30 major banks. 

Each time three quarters of the banks surveyed by the Wall Street Journal move their rate up or down, the WSJ Prime Rate is adjusted accordingly. Ultimately, this is why the WSJ Prime Rate is used on a daily basis by U.S. financial institutions.

How Has the Prime Rate Changed Over Time?

The prime rate today may seem high due to rate increases from the last few years, but it's not even close to where it's been in the past. Fortunately, we can see how rates have looked over the years since several financial institutions publish the historical changes of the prime rate over time. This includes J.P. Morgan Chase & Co.

The chart below shows a prime rate example over ten different datesstarting in 1980:

How the Prime Rate Is Determined

What is the prime rate? While we now know this rate determines how much interest we pay when we borrow money, there's plenty of mystery and intrigue that goes into where this rate comes from and how it's set.

Here's a rundown of how the current prime rate works:

• Who sets the prime rate? Individual banks set their own prime rates, yet they typically do so based on movements of the federal funds rate that is set by the Federal Reserve.
• How is the prime rate calculated? Each bank can set their prime rate independently, yet many take the federal funds rate and add 3.0%.
• Prime rate example: As an example, if the current prime rate is 8.25%, the current prime rate could easily be 11.25%.

Impacts of the Prime Rate

The impacts of the prime rate can cost you (or save you) tens of thousands of dollars over the years and potentially more. Here's a rundown of the potential impacts of the prime rate, both good and bad.

• Credit cards: Increasing the prime rate has a dramatic effect on the credit card interest rates consumers have to pay, and these variable rates are high to begin with. 
• Auto loans: A higher prime rate also leads to higher interest rates on auto loans for new and used cars, and this means higher car payments across the board.
• Mortgages: Increasing the prime rate means potential homeowners have to pay more interest in their housing payment each month. 
• Personal loans: Even the best personal loans will have higher interest rates when the prime rate goes up. Conversely, personal loans for bad credit see even higher rates than normal.

Prime Rate Example (Numbers Included)

How exactly does the prime rate influence the cost of borrowing? Consider the following examples:

Credit card example:

Imagine you have $10,000 in credit card debt at 16.04% APR, which is the average interest rate charged on credit cards assessed interest in 2018. Using a credit card interest calculator, you can see that paying $200 per month would help you pay off the full $10,000 in debt over the course of 82 months (a little under seven years). Over that time, however, you would fork over $6,312 in interest payments alone.

Now imagine you're stuck paying off this debt at 20.92%, which is the average rate on credit card accounts assessed interest as of February 2023. With the same $200 monthly payment, it would take you 115 months (9.5 years) to become debt-free and you would pay $12,885 in interest over that time.

Mortgage example: 

Now imagine you want to purchase a $300,000 home with a 30-year, fixed rate mortgage. If you paid the average 30-year mortgage rate of 4.40% in 2018, the monthly payment (principal and interest) would be $1,502 and you would pay $240,822 in interest over the course of 30 years.

If you took out the same mortgage with today's average interest rate of 6.43%, however, the same home would require a monthly payment of $1,882 and total interest costs would amount to $377,669 over 30 years.

Final Word

The prime rate may seem like an obscure concept, but you'll want to pay attention to this rate's movements over time. After all, the prime rate impacts how much interest you'll pay each time you borrow money, and that applies whether you're taking out a small business loan or business line of credit or you are taking out a mortgage or an auto loan.

You can't predict where the prime rate will go, but keeping an eye on it can help you make informed decisions when it comes to borrowing.