Prime Rate: What It Is And How It Affects You
Scott Steinberg6-minute read
April 03, 2021
What is the definition of “prime rate” and how does it impact current mortgage rates and loan products? If you’re shopping for a new home or interested in making a real estate investment, you’ve no doubt heard the term thrown around. As it turns out, the prime rate defined equates to the best interest rate at which any given financial institution will lend money to its most creditworthy and trusted clients.
In effect, the prime rate is the best possible rate that these financial providers are willing to offer borrowers on any sums lent. However, it is not generally available to average everyday consumers. But at the same time, shifting prime rates can also produce a trickle-down effect that impacts the interest rates charged on mortgages, credit cards and other financial instruments. Noting this, it’s important to understand how the prime rate works as you set about reviewing various credit and loan options.
What Is The Prime Rate?
For clarity’s sake, picture the prime rate as the most favorable interest rate that banks, credit unions, and other lenders will charge their customers. It is typically extended only to those clients with the highest credit ratings, for example, corporations and other large institutions, given the lower risks that these customers appear to present.
Serving as a helpful financial benchmark for lending institutions, the prime rate is also used as an underlying index to determine consumer interest rates and the costs associated with borrowing money via credit cards, lines of credit, car loans, home equity loans and home mortgages. When you apply for a personal loan, auto loan, or another financial product, the current prime rate will impact the terms that you receive. If it helps, imagine the prime rate as a starting point from which lenders begin to set the rates that they offer individual home buyers and consumers – and determine the margin of profit that they’d like to receive in exchange for their services. For example: In the context of real estate, a mortgage margin represents the difference between the index (for example, the prime rate) and the interest rate that is actually charged on a loan – a percentage of difference that the lender charges for any monies lent.
While financial institutions set the prime rate, not the government, the prime rate tends to move in lockstep with a benchmark interest rate set by the Federal Reserve. Note that the prime rate is influenced by and can fluctuate due to changes in the economy and can remain steady or shift depending on macroeconomic circumstances as well. If it goes up, you can expect adjustable-rate mortgages and variable credit card rates to trend upward, and if it decreases, you can expect them to go down as well.
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Today’s Current Prime Rate
The prime rate serves as an index that banks and credit unions use to set rates on consumer loan products. It also tends to change infrequently as the nation’s largest banks reconvene only periodically to make adjustments. You can click here to see where the prime rate sits today vs. last month and a year ago, and compare the changing prime rate’s impact on current mortgage rates here as well.
Historical Prime Rates
Looking at historical prime rates over time can prove a helpful exercise, as it provides a sense of where current credit and loan interest rates sit by comparison, and how they may change depending on shifting economic climates. Historical mortgage rates have tended to wax and wane based on a multitude of factors from inflation and recessions to economic growth and a boom or decline in housing markets. Even factors such as changes in oil prices can affect rates though, making it well worth keeping an eye on fluctuating prime rates, which can have a marked and significant impact on mortgage interest rates as well.
What Determines The Prime Rate?
Surprisingly, the Federal Reserve does not fully determine the prime rate. Rather, it’s set by the United States’ largest individual banking and financial institutions. At the same time, the prime rate may also be impacted by the federal funds rate (the interest rate that commercial banks charge each other to lend money via short-term loans), which the Fed does determine.
The prime rate often hovers around 3% above the federal funds rate (currently 0 – 0.25%), and presently sits at 3.25%. Noting this, if the Federal Reserve elects to raise interest rates, you can also expect the prime rate to go up as well.
On the bright side, while the prime rate can adjust anytime, it typically tends to shift only when a major benchmark and index – for example, the federal funds rate – is adjusted, such as during disruptive times like pandemics and receptions. Severe economic pullbacks are often a major predictor of pullbacks here, with the prime rate currently sitting at one of the lowest levels in years in the wake of COVID-19. Although capable of changing at any point, it’s not uncommon for years to pass without a major shift here.
Prime Rate Vs. Fed Funds Vs. LIBOR
Short for the London Interbank Offered Rate, LIBOR is a commonly utilized interest rate benchmark that has historically had an impact on mortgage rates. However, it is slowly being phased out through December 31, and will be retired by the end of 2021. Although consulted by global lenders in prior years, as above, the federal funds rate should prove a better predictor of prime rates going forward. You can read more about how LIBOR currently influences select types of mortgage (for instance, those with non-fixed interest rate payments attached) in this helpful overview and article.
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Why The Prime Lending Rate Matters For Your Mortgage
Although a baseline from which lenders start to determine interest rates on mortgages, personal loans, credit cards, and other financial products, the prime rate is not the actual interest rate that you can expect to pay on any sums lent. Rather, the actual interest rate that you will be asked to pay will be above the prime rate as determined by your financial lender. In other words, when determining interest rate vs. APR, and calculating monthly payments, prime rate will exert a large influence and impact over the ultimate size of these sums – but it won’t be the final determinant.
By way of illustration, you may find that APRs on many credit cards (which can fluctuate along with the prime rate) may top 15 – 20%, as determined by individual financial institutions and influenced by your credit history and credit score. The current prime rate can also exert considerable influence over real estate loan products that come with variable interest rates attached such as adjustable-rate mortgages and home equity lines of credit (HELOCs). If you’re wondering what your monthly payments on these loan products may look like, it helps to note that prime rate may impact various housing matters such as:
- Buying a home
- Refinancing a property
- Opening a HELOC
- Obtaining a bridge loan
- Accessing an FHA 203k loan
It may also help to be aware that the higher or lower the prime rate tends to go, the more likely it is that the cost of credit card or mortgage payments will go up or down as well. Should the prime rate decrease by a large enough amount, you may also wish to consider refinancing your mortgage or renegotiating credit cards to obtain better interest rates and pay less out of pocket as well.
Put simply: Adjustable-rate mortgages (ARMs) and variable loan products may be considerably influenced by a change in prime rate. But if you have locked in an interest rate on a fixed-rate financial product, your interest rate won’t impacted by the prime rate, as it was cemented at the time you applied for the loan. In addition, if the prime rate continues to remain low, and interest rates stay favorable for those wishing to borrow money (for example, prospective homeowners), it has the potential to positively impact predictions for this year’s housing market. Alternately, if the prime rate and mortgage interest rates should climb, it may negatively impact these projections as well.
The Bottom Line: Find Your Best Interest Rate
The prime rate is largely meant for corporate clients, not individuals, who are unlikely to obtain it. Rather, in the context of real estate transactions, it’s best thought of as a general barometer for how mortgage interest rates and payments may wax and wane.
Based on the prime rate, and current mortgage rates, you can utilize a mortgage calculator to see how current or future shifts in prime rate or interest rates may impact your mortgage payments. It will prove a helpful tool to help you budget and make sense of the possible impact if you choose to apply online for a home loan or refinance.
Mind you: While you won’t be able to secure the prime rate for yourself, you can still secure a favorable mortgage rate under today’s terms – especially if you have a high credit rating (700+) and strong history of timely payment. Bearing this in mind, you can still take steps to secure the best possible interest rate on a mortgage, personal loan, or other financial product.
By being mindful of your credit score, debt-to-income ratio (DTI), and the prime rate, you can ultimately secure lower interest rates and more loan options.
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