Do you know that there is a number that your loans, credit card rates, and even savings account interest rates are based upon? This number is called the prime interest rate, and each bank sets one. The bank will calculate all its other interest rates based on the prime interest rate. Here’s everything you need to know about prime rates and what they mean for you as a borrower.
What Is the Prime Interest Rate?
The Federal Reserve System sends out updates on the federal fund rates each morning. From this update, banks will set a prime interest rate, which is the base interest rate for all the bank’s loans.
Banks give the prime interest rate to the customers with the best credit score. Then, the bank will add a set percentage onto the prime interest rate for different loan types or for the risk the customer represents (due to their credit score.)
The Wall Street Journal publishes a prime interest rate each day. This published prime interest rate uses the standard prime rate calculation that many banks use, so it is a good average to keep in mind.
“The prime rate is an interest rate determined by individual banks. It is often used as a reference rate (also called the base rate) for many types of loans, including loans to small businesses and credit card loans,” according to the Federal Reserve.
How to Calculate the Prime Interest Rate
Each bank will set its own prime interest rate, so someone outside of the bank may not be able to calculate the prime interest rate.
However, there is a standard prime interest rate calculation that banks use. It is so common, that the Wall Street Journal uses that rate when they publish the daily prime interest rate.
The calculation is:
The Federal Reserve System’s federal fund overnight rate + 3.
As the federal fund rate changes, so too will the prime interest rate because even if the bank does not use the +3 formula, they will still base their prime interest rate on the federal fund overnight rate.
How Does the Prime Interest Rate Work?
The prime interest rate is a bank’s base interest rate. It is the lowest possible rate a bank will offer and is usually reserved for the most reliable borrowers (usually only large corporations with excellent credit.)
Aside from being an interest rate that they offer, the prime interest rate acts as the base rate for all of the bank’s loans. They will create a formula for the risk of the loan based on the type of loan, the borrower’s financial situation, and any other pertinent factors. For example, the bank may add 5% on top of the prime interest rate for a low-risk loan. The percentage added to the prime interest rate will reflect the degree of risk. Each bank will have its own formula that takes into account factors like:
- The risk of the loan
- The term of the loan
- The borrower’s credit score
- The borrower’s credit history
Banks can offer interest rates lower than the prime interest rate if they wish – after all, banks set their own interest rates. However, it is rate for them to offer rates lower than the prime interest rate.
Why Is the Prime Interest Rate Important?
The prime interest rate is important for borrowers to know because interest rates will change as the prime interest rate changes. If a borrower has a loan with a variable interest rate, then that means that the interest rate on their current loan will change. A fixed-rate loan will not change as the prime interest rate does because the interest rate is fixed for the full duration of the loan term.
Banks often won’t provide borrowers with the information about what their prime interest rate is or if they borrower received the prime interest rate. The borrower can get an idea of what the prime interest rate may be by looking at the rate published in the Wall Street Journal.
A business concerned with the prime rate, especially in terms of its impact on loans, credit lines, or overall financial strategy, would typically seek the expertise of a commercial attorney. Commercial attorneys can provide guidance on how changes in the prime rate may affect a business’s existing financial obligations and future financial planning, including the negotiation and drafting of loan agreements that may be influenced by fluctuating interest rates.
What Is Affected by the Prime Interest Rate?
The prime interest rate and changes to the prime interest rate will affect:
- Existing loans on a variable interest rate, like variable rate mortgages, credit cards, etc.
- Home equity loans
- Small business loans
- Credit card balances
- Adjustable rate mortgages
Check your loan information to see if your interest rate is fixed or variable. A variable interest rate will be impacted by changes to the prime interest rate.
What Is Not Affected by the Prime Interest Rate?
Changes to the prime interest rate will not affect:
- Existing loans on a fixed interest rate, like savings accounts, fixed-rate mortgages, and student loans.
- Fixed rate mortgages
- Savings accounts
The prime interest rate will impact the interest rates of any fixed rate loans a borrower is considering. If the prime interest rate changes before they have a guaranteed interest rate, then the interest rate may change, too.
How Has the Prime Interest Rate Changed Historically?
The first use of the prime interest rate was in 1930, after the Great Depression. Up until the 1970s, the prime interest rate was stable at an average of 2-3%. As inflation rose, so too did the prime interest rates. Remember, it’s connected to the Federal Reserve’s federal fund rates, so when the Federal Reserve increases interest rates to help the economy recover, banks will update their prime interest rate in kind.
The highest prime interest rate on record was recorded in 1980. It was 21.5%.
In 2020, the prime interest rate was 3.25%. In 2023, the prime interest rate was 8.5%
Prime Interest Rates Summarized
The prime interest rate is a bank’s basic interest rate, set based on the Federal Reserve System’s federal fund rate. Banks give the prime interest rate to the customers with the best credit, usually large corporations with impeccable credit. The most common use of the prime rate is as the base rate from which banks set their other interest rates. Banks create a formula for how much will be added to the prime interest rate based on the risk of the loan. The bank may consider factors like the type of loan, the term of the loan, and the borrower’s financial situation.
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