What Is The Prime Rate, How Does it Work And How Does It Affect You?

Last updated: March 16, 2020

If you’re shopping for a new home or interested in making a real estate investment, you’ve probably heard the term “prime rate” thrown around. The prime rate impacts current mortgage rates, as well as loan products. As it turns out, the prime rate 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 mortgage rate that these financial providers are willing to offer borrowers on any sums lent. However, it’s not generally available to average everyday consumers.

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.

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 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 other financial product, the current prime rate will impact the rate 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 (e.g., 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.

The prime rate often hovers around 3% above the federal funds rate. On May 5, 2022, The Federal Reserve lifted the previous target range (0% – 0.25%) to now 5.50%. Due to this increase in interest rates, the prime rate is expected to go up as well. Note that this is the largest Fed rate hike since 2000.

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. It’s best to see where the prime rate sits today versus last month and a year ago, and compare the changing prime rate’s impact on current mortgage rates here as well.

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 tend 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 in turn have a marked and significant impact on mortgage interest rates.

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.

Factors That Influence The Prime Interest Rate

While financial institutions set the prime rate, not the government, the prime rate tends to move in lockstep with interest rates 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 those to go down.

Prime Rate Vs. Fed Funds Vs. LIBOR

Short for the London Interbank Offered Rate, LIBOR was a commonly utilized interest rate benchmark that has historically had an impact on mortgage rates. However, it was phased out at the end of 2021 and The Secured Overnight Financing Rate (SOFR) has now replaced LIBOR in the United States.

It’s important to note that although global leaders have consulted about interest rate predictions, the federal funds rate should prove a better predictor of prime rates going forward.

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 money you borrow. Rather, the actual interest rate that you’ll be asked to pay will likely be above the prime rate as determined by your financial lender. In other words, when determining interest rate versus 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 a FHA 203(k) loan

Below are a few commonly asked questions regarding prime rate.

Is there a limit on how high the prime rate can go?

To put it simply, no, there isn’t a limit on how high the prime interest rate may rise. If the Federal Reserve deems it necessary to raise the federal funds rate – and thus, indirectly, the prime rate, they have the right to do so.

How often does the prime rate change?

While the prime rate can adjust any time, it tends to majorly shift only when a benchmark – for example, the federal funds rate – is adjusted. Severe economic pullbacks are often a major predictor of when the prime rate will drastically change, such as COVID-19, when the prime rate was at one of the lowest levels. Although the prime rate is capable of changing at any point, it’s not uncommon for years to pass without a major shift.

Can the prime rate affect your mortgage payments?

The higher or lower the prime rate tends to go, the more likely it is that the cost of credit card or adjustable-rate 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’ve locked in an interest rate on a fixed-rate financial product, your interest rate won’t be 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 (e.g., 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 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.

While you may not be able to secure the prime rate for yourself, you can still secure a favorable mortgage rate, especially if you have a high credit score (700+) and strong history of making timely payments. By being mindful of your credit score and debt-to-income ratio (DTI), you can ultimately secure lower interest rates and more loan options.

Based on the prime rate and current mortgage rates, you can use 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 when you buy a home or refinance.