The prime rate is the interest rate that banks charge borrowers who are the most trustworthy—or “creditworthy”—based on their borrowing history.
What is the Prime Rate?
When borrowing money from a bank or other financial institution, you’ll be required to pay interest. Interest is an amount of money above and beyond the amount you’ve been loaned. (Basically it represents the “cost” of borrowing.) The more interest you’re being charged, the more expensive your loan. When interest is charged as a percentage of the principal over a certain period of time, it’s called an “interest rate.”
The amount of interest you’re charged will typically be based on your credit rating. A prime rate is what lending institutions offer to the most creditworthy customers. These borrowers have excellent credit scores, and there is less risk involved when lending to them.
Remember, most banks don’t just lend to individuals—they also lend to businesses. Most often, a prime rate is reserved for large corporations.1
Rates vary from bank to bank, so when someone refers to the prime rate, they’re likely referring to the average prime rate that is calculated and published by a variety of sources.
How does the Prime Rate work?
The prime rate is affected by the federal funds rate, which is determined by the Federal Reserve. The federal funds rate is the interest rate charged to banks that borrow from one another or from the Federal Reserve.
While the federal funds rate might influence the prime rate that banks offer, it doesn’t determine it—the federal funds rate is basically just a benchmark. However, if the federal funds rate goes up or down, the banks will see it as an indication of where the economy is moving and adjust their prime rates accordingly.
If you have excellent credit, a bank may choose to offer you a rate just above the average prime rate. (The more creditworthy borrowers are, the lower their rate will be.) The prime rate serves as a benchmark for loans such as mortgages and credit cards.
Sometimes the rate offered may be expressed as the prime rate plus an additional percentage. For instance, you may be offered a personal loan with a rate of “prime plus seven percent.” So if that particular bank has a prime rate of five percent, you’re being offered a 12-percent total interest rate.2
How do I know if I have good credit?
Check your credit score to find out if you have good credit. Your credit score is a three-digit number that’s based on the information in your credit report. Credit reports are created and updated by the three major credit bureaus—TransUnion, Experian and Equifax—and information on the report can differ from bureau to bureau.
Your credit score takes the information on your credit report—like how much you owe and whether or not you pay your bills on time—and uses a formula to create a three-digit number. Think of your credit score like a numerical grade on what’s in your credit report.
The most common type of credit score is a FICO score, and it’s based on a scale from 300 to 850. The higher your credit score, the more likely you are to qualify for a loan at, or near, the prime rate.2
Where can I find the Prime Rate?
The current prime rate is available online. It’s published by a number of sources including the Wall Street Journal, which is considered the official source for it. To calculate the prime rate, the paper conducts a daily survey of corporate loans from 75 percent of the 30 largest banks in the U.S.3
Is the Prime Rate going to rise?
The prime rate typically follows the federal funds rate determined by the Federal Open Market Committee (FOMC) of the Federal Reserve Board. If the FOMC raises the rate that it charges to banks, the prime rate will likely increase. If the FOMC lowers its rate, the prime rate will likely drop too.4
Though the prime rate is not set by the FOMC (and the prime rate of one bank may be different from the prime rate of another), an increase or decrease in federal funds rates will affect prime rates elsewhere. The FOMC adjusts the federal funds rate according to changes in the economy. When the economy is struggling, rates are kept low. When the economy is strong, rates are increased. If the economy looks like it’s on an upswing, it might be an indication that the prime rate will increase in the future.
2 Credit Karma. What’s a good credit score? Retrieved from https://www.creditkarma.com/what-is-a-good-credit-score
4 SF Gate. How often does a prime rate change? Retrieved from http://homeguides.sfgate.com/prime-rate-change-8904.html