Takeaways
- The prime rate is the interest rate U.S. commercial banks charge their best customers.
- The prime rate affects credit products like credit cards, mortgages, and personal loans.
- The prime rate is usually 300 basis points above the federal funds rate.
- The prime rate is given to the highest creditworthy customers and clients.
- Lower creditworthy customers receive the prime rate plus an additional interest rate based on their credit score and report.
What Is the Prime Rate?
The prime rate is a key interest rate in the United States that commercial banks use as a base rate to set interest rates. Also known as the prime lending rate, the current prime rate helps U.S. commercial banks determine what to charge for various credit products.
This rate is primarily influenced by the Federal Reserve's adjustments to the federal funds rate. This federal fund rate is the rate at which banks lend to each other overnight. The prime rate typically runs about 3% points above the federal funds rate to serve as a benchmark for various commercial, business, and consumer loan products.
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The prime rate as of January 9, 2025, was 7.50%.[1] This number is determined by the prime rate of the top 25 largest U.S. banks.
How the Prime Rate Works
The prime rate is a highly referenced interest rate that influences the cost of borrowing for consumers and businesses. The largest banks set this rate based on the federal fund’s target rate, determined by the Federal Reserve.
It is a benchmark for various types of loans and credit products, including:
Since the prime rate is usually about 3% higher than the federal funds rate, it creates a margin that covers the risks of banks associated with lending and helps ensure loan profitability.
The actual rate offered can vary depending on your credit score and report. Generally, the most creditworthy customers will receive interest rates close to the prime rate. Banks do this because borrowers with super-high credit scores are less likely to default on their loans.
Alternatively, customers with poorer credit and higher risk profiles will receive interest rates well above the prime rate. This is because banks and credit unions perceive these borrowers to be at a higher risk of default based on their credit reports.
Read More: 7 Easy Steps to Get Your Free Credit Report
Banks may adjust the prime rate in response to changes in the federal funds rate. If the Federal Reserve raises the federal funds rate to combat inflation, banks have a corresponding increase in the prime rate, making loans more expensive.
On the other hand, if the Federal Reserve lowers the federal funds rate to stimulate spending, banks usually lower the prime rate, making borrowing cheaper.
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Determining the Prime Rate
Major banks in the United States primarily determine the prime rate based on the federal funds target rate set by the Federal Reserve.[2] The federal funds target rate is the interest rate at which banks lend to each other overnight, and it influences the prime rate because it affects banks' capital costs.
The Wall Street Journal plays a crucial role in setting the U.S. prime rate by publishing a rate that reflects the base rate on corporate loans posted by at least 70% of the ten largest U.S. banks.[3] This rate usually precedes other lending rates throughout the banking system.
Read Also: What Is Compounding Interest?
Banks adjust the prime rate when the Federal Reserve changes the federal funds rate at the Federal Open Market Committee Meeting (FOMC), which takes place eight times a year. If the Federal Reserve raises the federal funds rate to combat inflation, banks will likely increase the prime rate, making borrowing more expensive and slowing economic growth.
Because of the above, the Federal Reserve does influence the prime rate by setting the federal funds rate. It is important to note that each bank ultimately sets its own prime rate. Therefore, a prime rate can vary slightly among banks based on their specific capital needs and banking strategy.
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How the Prime Rate Affects Borrowers
The prime rate influences the interest rates on various financial products such as credit cards, mortgages, and loans. When banks set their prime rate, it becomes the baseline for determining the annual percentage rates (APRs) on credit products.
Changes in the prime rate can affect your APR, potentially altering your minimum monthly payment amounts as the prime rate fluctuates. Suppose you have loans like a home equity line of credit or adjustable-rate mortgage. In that case, the interest rates are typically tied to the prime rate with an additional margin your lender determines.
When the prime rate rises, so do the interest rates on variable loans. This can increase or decrease your monthly payments. If the prime rate rises, your monthly payments increase; if the prime rate falls, so do interest rates and your payments. You must ensure your budget has enough buffer to handle these dynamic increases in monthly minimums.
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The prime rate also affects business and personal loans. A higher prime rate can increase borrowing costs, affecting business operations and personal finances. Fixed-rate loans might not be directly affected by changes in the prime rate. However, your variable-rate products will immediately impact interest charges and payment amounts.
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History of the Prime Rate
The prime rate has experienced significant fluctuations. It reached historically high levels in the late 1970s and early 1980s, peaking at 21.5% in December 1980. This was due to high inflation and aggressive monetary policies instituted by the Federal Reserve to control runaway inflation.
In contrast, the prime rate falls to historic lows during economic recessions, especially following the 2008 financial crisis. In December 2008, it reached as low as 3.25%, which occurred again in March 2020 in response to the economic impact of the COVID-19 pandemic.
Changes to the prime rate have been linked to the Federal Reserve's adjustments to the federal funds rate as it responds to varying economic conditions. The federal funds rate aims to influence economic activity, control inflation, and maintain employment.
Smart Summary
The U.S. prime rate is the interest rate given to banks' best and most creditworthy customers. Most of the credit products you use daily, like credit cards, mortgages, and auto loans, are tied to the prime rate plus an additional amount of interest based on your unique credit history. The closer your interest rates are to the prime rate, the better deal you are getting. This is why it pays to keep a high credit score.
You Might Also Like:
(1) Federal Reserve. Select Interest Rates (Daily). Last Accessed January 16, 2025.
(2) Federal Reserve. What is the Prime Rate, and does the Federal Reserve set the prime rate? Last Accessed January 16, 2025.
(3) Wall Street Journal. Money Rates. Last Accessed January 16, 2025.
