Your Quick Guide To The U.S. Prime Rate

Seeing recent news on interest rates changing may have you wondering how banks set their rate. While lenders do have a part in the interest rate they charge, larger economic trends and other factors affect the rate you receive when applying for a loan. For instance, the Federal Reserve’s activity, your loan type and what banks charge each other all play a part in the prime rate. While the least risky borrowers may receive an interest rate closer to the prime rate, the average borrower will receive a marked-up rate from this benchmark.

What Is The Prime Rate And Why Is It Important?

The prime rate, also known as the prime interest rate or prime lending rate, is the benchmark rate for loans for individual borrowers. Banks may off this rate – or close to it – to clients who present the least amount of risk. In other words, the prime rate is the best interest rate currently available from lenders. As a result, the customers most likely to pay their loan back can obtain the prime rate, which functions as a benchmark for loans for individual borrowers. These clients are typically corporate clients, not the average consumer.

A bank assesses a borrower’s credit score and financial circumstances to determine if it will provide a loan. Then, it will use the prime rate as the base rate in its calculation for how much interest it will charge.

While banks decide the prime rate, the Federal Reserve also influences lending. Specifically, the Reserve’s Federal Open Market Committee (FOMC) meets six times per year to adjust the federal funds rate, which impacts the prime rate. In addition, banks use the Secured Overnight Financing Rate (SOFR) and treasury bill rates to set the prime rate.

Why Do Banks Use The Prime Rate?

Commercial banks use the prime lending rate to create a basis for how much it costs customers to borrow. Lenders change the rate over time to respond to emerging economic trends. This way, customers receive interest rates on short-term loans that match current market dynamics. As a result, the prime rate is a flexible tool allowing banks and their customers to negotiate with realistic terms.

How To Find The Current Prime Rate

The quickest way to find the current prime rate is to use the Wall Street Journal’s website. WSJ has published the official U.S. prime rate for decades, providing consumers with information about current interest rates. Plus, it provides the most recent federal funds rate, which influences the prime rate. Whenever the Federal Reserve Bank sets new rates, WSJ updates its information online and in print. As a result, the average consumer who doesn’t keep tabs on every move the Fed makes can easily access data on interest rates.

Comparing The Current Prime Rate To Historical Prime Rates

The prime rate’s history shows it has jumped up and down during the last decade. Specifically, the prime rate was 3.25% in 2013. Then, it rose to 5.5% in 2019 before returning to its previous level in 2021. However, supply chain issues, global conflict and inflation have caused the prime rate to more than double in the last year, and, as of March 29, 2023, it sits at 8%. As a result, financial institutions have raised interest rates, making debt far more expensive for consumers than in previous years.

How Does The Prime Rate Affect Borrowers?

The prime rate is the bare minimum rate banks charge for loans. However, lenders charge more than the prime rate for consumer credit because of the increased risk. Therefore, you’ll pay a marked-up version of the prime rate for new debt.

The size of the markup depends on the amount of risk you display. For example, your debt-to-income ratio (DTI) indicates how much room you have in your budget for another debt payment. In addition, your credit history shows how reliable you have been in the past as a borrower. The higher your risk of default, the higher the rate a lender will charge. The type of loan also matters. For instance, a mortgage or refinance rate differs from one for a personal loan.

Remember, prime rate changes affect all loans lenders give, including business credit. Business clients usually pose a lower risk of default, so they’re more likely to receive an interest rate closer prime rate.

That said, here are the various loan types the prime rate influences.

Mortgages

Remember, while the prime rate guides interest rates, your rate for a mortgage isn’t completely predetermined. Homeowners can get better mortgage rates through a high credit score, healthy DTI and solid credit history. In addition, it helps to pay off lingering debts and provide a larger down payment than the minimum requirement. Likewise, buying mortgage points at closing can also score you a better loan rate.

The prime rate provides a foundation for lending in the mortgage market. Specifically, adjustable-rate mortgages have a direct link to the prime rate, while fixed-rate mortgages are tied closely to the SOFR. Here is a breakdown of the two mortgage types.

Fixed Rate

If you lock in a fixed mortgage rate with a lender, the prime rate won’t affect the rate you receive. Specifically, fixed-rate mortgages are usually lower than the prime rate because lenders sell mortgages to major mortgage investors, such as Fannie Mae and Freddie Mac.

These entities purchase mortgages and package them with thousands of others to create investment vehicles. For example, investors can fill their portfolios with conventional loans with 20% down payments and 750 median FICO^® Scores. As a result, the better your qualifications as a borrower, the lower your rate will be because an investor will trade a lower return for lower risk.

There is also a market component to mortgage rates because investors purchase mortgages on the bond market. The attractive part of bonds for investors is that they offer a guaranteed rate of return. However, bonds have two downsides: if inflation increases at a higher rate than the rate of return, investors will lose money. Second, bonds don’t offer the yield that comes with higher-risk investments, like stocks.

In general, if investors feel confident about the economy, they’ll prioritize stocks over bonds. If they see a downturn in the future, the opposite is true. So, both the market and your finances impact interest rates in real estate.

Adjustable Rate

Adjustable-rate mortgage (ARM) rates have two phases. The introductory phase has a lower interest rate set the same way as a fixed-rate mortgage. Lenders call this the initial or “teaser” rate because it lasts for the first part of the loan, usually 1 – 10 years.

After the introductory period, the rate adjusts, and the prime rate benchmark comes into play. Your lender will use the prime rate as the benchmark and add a margin on top of it, resulting in your interest rate.

ARM rates adjust according to the terms of your loan, so you’ll always pay the margin plus the prime rate or whichever benchmark the lender chooses. In addition, these loans have variable interest rates because they change at specific intervals.

Most adjustable-rate loans adjust every 6 months to a year, but their fixed period varies. For example, a 5/1 ARM has a fixed rate for 5 years and then adjusts annually for the remainder of the term. On the other hand, a 7/6 ARM has a fixed rate for 7 years and then adjusts every 6 months.

Auto Loans

The prime rate influences car loans because lenders use it as the starting point in the industry. Then, the consumer’s creditworthiness determines how much margin the lender adds to the baseline. Therefore, auto loans become more expensive if the prime rate rises.

Small-Business Loans

Prime rates impact borrowers with small-business loans because lenders derive rates mainly from the prime rate. In addition, business loans can be lower because they present less risk to the lender. In other words, small-business loans have less margin added to the prime rate.

Credit Card Debt

Similarly, financial institutions use the prime rate as the starting point for credit card interest rates. However, credit cards receive significantly more margin than other forms of debt. As a result, interest rates are higher for credit cards.

Home Equity Lines Of Credit

Home equity lines of credit (HELOCs) also use the prime rate setting interest rates. Because HELOCs have variable interest rates, the prime rate is a factor. Conversely, home equity loans are like mortgages because they have fixed interest rates. As a result, they don’t rely on the prime rate. 

Types Of Loans That Aren’t Affected By Prime Rate Changes

While the prime rate drives interest rates in multiple sectors of the lending industry, numerous loan types are independent of it. For example, student loans don’t use the prime rate. Instead, Congress sets student loan rates using the most recent 10-year Treasury note’s interest rate.

Likewise, the prime rate doesn’t determine the interest rate of savings accounts. Instead, banks consider a variety of rates and set an interest rate they think will draw customers. Of course, wild changes in the prime rate indicate changes in the lending industry, affecting the return from savings accounts. However, the prime rate isn’t the sole or official basis for savings account rates.

How The Prime Rate Is Different from A Target Rate

The Federal Reserve sets a target rate every few months for banks to use when they lend money to each other. This rate influences how banks lend money to institutions and individual borrowers. In addition, it provides the basis for the prime rate, which is usually a few points higher.

Prime Interest Rate FAQs

Banking is a complex industry, and prime interest rates are one facet among many. Here are some answers to commonly asked questions to round out your understanding.

What is the prime rate vs. the Fed rate?

The Fed rate is a suggested rate for banks to use when loaning money to each other. This rate provides the foundation for the prime rate, which banks use to charge borrowers. Banks create the prime rate by adding a margin to the Fed rate.

What is a bank’s prime rate?

A bank’s prime rate is the minimum interest rate it charges customers for loans. The prime rate depends on the current market dynamics.

How often does the prime rate change?

The prime rate doesn’t have a set schedule for when it changes. Instead, it responds to emerging economic dynamics. Generally, it changes when the federal funds rate adjusts. As a result, economic stability can result in years without the prime rate changing.

Is there a limit on the prime rate?

The prime rate has no limit in either direction. So, it can be as low or as high as the lending industry sees fit.

The Bottom Line: The Prime Rate Affects Many Borrowers

The prime rate is the benchmark rate that banks add a margin to when lending to individual borrowers, raising the interest rate as they identify increased risk. As a result, the prime rate determines numerous loan types, such as adjustable-rate mortgages and auto loans. Plus, it indirectly affects additional loan types and reflects overall lending trends.

Fortunately, you can lower your mortgage interest rate by strengthening your credit and optimizing your financial situation. Plus, you can reduce your rate by buying points when you close.