If you’ve ever taken out a short-term loan, adjustable mortgage, private student loans, or owed money on a credit card, you’ve been impacted by the “prime rate”. If you don’t know what the prime rate is, you’ll definitely want to become familiar prior to taking out a loan or line of credit, as it will impact the current interest rate you would be paying on the debt and the future rate.
The prime rate can have immense implications on your finances and it is essential for personal finance beginners to understand it before they start borrowing money. So, I’ll discuss what the prime rate is, how it’s calculated, today’s prime rate, the historical prime rate, and how it can impact your APR and your bottom line.
Prime Rate Vs. the Federal Funds Rate
To understand what prime rate is, you must first understand how it is derived and calculated. The prime rate, in general, is the lowest rate of interest commercial banks charge their most credit-worthy customers. How do they come up with this rate?
This prime rate is derived from the Federal Funds effective rate, which is the interest rates at which banks lend money to each other. The Federal Reserve provides guidance on what the Fed Funds rate should be set at, known as the “Federal Funds target rate”. Banks usually follow suit, and you have the “Fed Funds effective rate”.
From there, prime rate is calculated by adding ~3% to the fed funds rate.
Today’s Prime Rate
The prime rate today is 3.25%, but that will likely be increasing in the coming years due to inflation concerns.
The Federal Reserve lowered the rate dramatically at that point of time due to the credit crisis preventing the flow of credit in the economy. The Fed had kept their target rate at that historically low level, in order to keep credit cheap, with the hopes that it would stimulate the economy.
Prime Rate History
When looking at the historical prime rate, you must first look to the historical fed funds rate. There has not been a steady funds rate over history. It peaked in December of 1980 (when inflation was in the double digits) at 19-20% – and the prime rate followed suit, reaching a record high at 21.50%. Since, it’s generally shifted downwards.
While it will likely not reach peak heights again, you can see that historically, the fed funds rate (and hence, the prime rate) has been at levels much higher than we have become accustomed to in recent years.
How Does Prime Rate Impact You?
Every line of credit or loan has an interest rate in the form of a quoted APR (annual percentage rate), that you pay. Sometimes these rates are locked (e.g. fixed rate mortgages). But many times, they are not.
Those with unlocked, or variable rates include:
- credit cards
- home equity line of credit (HELOC)
- some private student loans
- adjustable rate mortgages (ARM)
All of them determine the present APR that you pay on that loan by taking a fixed rate (as specified in your contract) and adding the prime rate to it.
So a credit card, for example, could say that your actual APR will be 9.99% + prime rate. An ARM could state your APR as 3% + prime rate.
The fixed rate used varies by the type of loan and each individual lender.
Why is it important? Three reasons:
- Loan Rate Comparisons: When comparing loans, it’s important to understand the difference between a variable and fixed rate loan. Variable rate loans may appear to be very attractive vs. a fixed rate at a given time, but if the prime rate were to increase, that may no longer be the case.
- Historical Prime Rate Implications: Many variable rate loans, particularly HELOCs, appear to be very attractive at the moment. However, if prime rate were to increase, they might not stay attractive. You need to be wary of this prior to taking out any variable rate loan. What if you had an ARM, for example, and the prime rate went back up to historical highs in 20 years? You’d be paying 20%+ on your mortgage. Not good.
- Rate Locking: Some loans allow you to lock in your rate. There has been no better time to lock in a rate than right now, with Prime rate being at a historical low. In other words, your APR cannot get any lower than this (unless you negotiate it to be), so you might as well lock it in before it eventually increases.
Prime Rate Discussion:
- Can you see any other prime rate implications I haven’t listed?
- Have you locked in a rate on a loan recently?
- What is Private Mortgage Insurance?
- When to Refinance a Mortgage
- How Much Should you Put Towards a Down Payment?
- Don’t Avoid a 20% Down Payment on your Mortgage
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