You have probably heard the term prime rate mentioned in financial news or have seen it in the terms for various loans and credit cards. So what is the prime rate and how does it affect your financial situation?
The prime rate is based off of the Federal Funds Rate, this is the rate that the federal government generally charges interest at for money borrowed from them by banks from day to day. The prime rate itself is almost always 3 percent (or 300 points) above the federal funds rate, no matter what the federal funds rate is.
Therefore if the federal funds rate is at 3.00%, then the prime rate would be 6.00%. The prime rate affects a wide range of interest rates including those on home mortgages, loans, and credit cards.
You might be wondering then if the prime rate is 3.00% more then the federal funds rate why are the interest rates on many credit cards and loans higher then that number? Besides the obvious reasons of making profits off of interest earned, the interest rates on credit cards are generally variable rates. The companies issuing credit cards or loans can set their own rates, so they may add on additional interest to the prime rate.
The prime rate is commonly used because it is a good standard in the industry, can help regulate the lending industry and in fact the federal government plays a big roll in the ups and downs of interest rates.
You may have also noticed on credit cards in particular, there are generally different pricing scales for a credit card. The interest rate may be under 10% including the prime rate, but then there will be 2 or 3 other tiers where the rate can go up to 20% (such as gold and platinum pricing tiers). This doesn’t include default rates, but based on credit history, the card itself, and the market you may find yourself on the lowest rate or the highest rate offered for the credit card you have.
For the most part the prime rate does not change often because the federal funds rate rarely changes. However in difficult economic times the federal reserve may lower the rate to stimulate drops in variable interest rates. These decreases also encourage banks to continue to lend to consumers, otherwise in bad economic times many banks will hold onto money rather then lend it. Overall the prime rate stays around the same and most lending businesses such as banks and credit card issuers continue to base their interest rates off of the prime rates.