The Prime Interest Rate: How It’s Set – and Affects You

The prime rate explained

…[Many assume]… that the Fed sets the prime but it doesn’t…Changes in the prime are not dictated by the Fed, although the prime rate is closely tied to the federal funds rate.

• Each time the central bank gives the federal funds rate a nudge — in either direction — the big banks quickly make a matching move with the prime.
  • For example, when the Fed announced a quarter-point cut in interest rates back in October from 5% to 4.5% the major banks lowered the prime by a similar amount.
  • No changes in rates were announced at its December meeting, so the prime has held steady at 4.75%.

Why the prime rate moves

Federal Reserve officials set their target for the federal funds rate based on how well the economy’s growing, and on the outlook for inflation.

• Whenever the economy is booming in a way that could heat up inflation, the central bankers raise the federal funds rate to keep spending and prices under control – and the prime lending rate goes up, too.
• The Fed tends to lower its interest rate where there are trouble signs for the economy, or in times of weak inflation – and that pushes down the prime…

What the prime rate means for you

If you’ve got credit cards…or a home equity line of credit (HELOC) you feel the movements in the prime rate most directly [as] rates on those products change in lockstep with the prime.

• In fact, the adjustable rate on a HELOC might be advertised as “prime plus 1%” or “prime plus one,” for example, meaning that the rate on a hypothetical home equity line will slip from 6.5% to 6.25% because the prime has fallen from 5% to 4.75%.
• You can expect to pay lower interest on your plastic or your HELOC as soon as several weeks after any Fed rate reduction.

The prime rate and other loans

Rates on auto loans, personal loans and some adjustable-rate mortgages also piggyback off the prime.

• Mortgage rates have dropped to the lowest levels in nearly three years as the Fed has cut rates
• and, while fixed mortgage rates don’t necessarily follow the lead of the federal funds rate and the prime, they can be influenced by those benchmarks indirectly

Conclusion

Timing is crucial when you’re deciding to borrow money…[so] latch onto a lower rate whenever you see one.

Editor’s Note:  The above excerpts from the original article by Esther Trattner have been edited ([ ]) and abridged (…) for the sake of clarity and brevity.  The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.  Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.

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