The prime interest rate is the percentage that U.S. commercial banks charge their most creditworthy customers for loans. Like all loan rates, the prime interest rate is derived from the federal funds’ overnight rate, set by the Federal Reserve at meetings held eight times a year. The prime interest rate is the benchmark banks and other lenders use when setting their interest rates for every category of loan from credit cards to car loans and mortgages.
As of April 2024, the prime interest rate was 8.5%. The federal funds rate was set at 5.25% to 5.50% in July 2023. The Federal Open Market Committee (FOMC) kept the rate at this range in its last meeting on March 20, 2024.
Key Takeaways
- The prime rate is the interest rate that commercial banks charge their most creditworthy corporate customers.
- The prime rate is derived from the federal funds rate, usually using fed funds + 3 as the formula.
- The rates for many other loans, including mortgages, small business loans, and personal loans, are based on the prime rate but can fluctuate due to other factors such as loan demand.
- While the most creditworthy clients get the prime rate, all others get an interest rate based on their credit score plus a percentage on top of the prime rate.
- The most commonly quoted prime rate is the one published daily by The Wall Street Journal.
Unveiling How the Prime Rate Works
An interest rate is the percentage of a loan amount that a lender charges. It is the lender’s compensation, and the percentage varies with each type of loan. Generally, any unsecured loan, such as a credit card balance, is charged interest at a higher rate than a secured loan such as an auto loan or a mortgage.
The rate that an individual or business receives will vary depending on the borrower’s credit history and other financial details.
These rates are normally defined as an annual percentage rate (APR).
The Federal Funds Rate
The prime interest rate, also called the prime lending rate, is largely determined by the federal funds rate set by the FOMC of the Federal Reserve.
The fed funds rate is the overnight rate banks and other financial institutions use to lend money to each other. The process is a constant electronic flow of money that ensures that each bank has sufficient liquidity to operate from day to day.
Determining the Prime Rate
Banks generally use a formula of the federal funds rate + 3 to determine the prime rate it charges its best customers, primarily large corporations that borrow and repay loans on a more or less constant basis.
That prime rate is the starting point for all other interest rates, which are set at the prime rate plus an additional percentage.
The bank sets a range of interest rates for each loan type. The rates individual borrowers are charged are based on their credit scores, income, and current debts.
For example, a person with an outstanding credit score might be charged, say, prime plus 9% for a credit card, while an individual with only a good score might get a rate of prime plus 15%.
The prime rate plus a percentage forms the base of almost all consumer and business interest rates.
The Real-World Impact of the Prime Rate
The prime rate affects a variety of bank loans. When the prime rate goes up, so does the cost of obtaining small business loans, lines of credit, car loans, mortgages, and credit cards.
Debt with a variable interest rate can be affected by the prime rate because a bank can change your rate. This includes credit cards as well as variable rate mortgages, home equity loans, personal loans, and variable interest rate student loans.
The prime rate is reserved for only the most qualified customers, those who pose the least amount of default risk. If the prime rate is set at 5%, a lender may still offer rates below 5% to well-qualified customers. The prime rate in Canada was 7.20% and 1.48% in Japan as of January 2024.
How Does the Prime Rate Affect Borrowers?
The prime rate is not fixed and can change over time based on changes in the federal funds rate, inflation, the demand for loans, and other economic factors. When the prime rate changes, the interest rates on loans and financial products that are based on the prime rate may also change.
The prime rate can affect you in various ways, depending on the type of loan or financial product you have. Here are some common scenarios:
- Home Equity Loans: If you have a home equity loan or home equity line of credit (HELOC), the interest rate on the loan may be based on the prime rate. If the prime rate increases, so does the interest rate, leading to higher monthly payments.
- Adjustable-Rate Mortgages (ARMs): If you have an ARM that is tied to the prime rate, an increase in the prime rate may result in higher monthly payments due to a higher mortgage interest rate.
- Credit Cards: If you have a credit card with a variable interest rate, the interest rate on new purchases may increase when the prime rate increases, leading to higher interest charges.
- Small Business Loans: If a small business has a loan with an interest rate based on the prime rate, an increase in the prime rate may result in higher loan payments.
The Historical Journey of the Prime Rate
The prime rate dates back to the 1930s when banks first used it to set interest rates for short-term lending to their most creditworthy customers following the Great Depression. In the decades following World War II, the prime rate remained relatively stable, hovering around 2% to 3%.
The prime rate began to rise significantly in the 1970s as the United States experienced an economic recession and high inflation. The prime rate reached its all-time high of 21.5% in December 1980 as the Federal Reserve sought to curb inflation by raising interest rates.
Over the next few decades, the prime rate fluctuated widely, reflecting the ups and downs of the economy and largely mirroring other benchmark interest rates. During times of economic growth, the prime rate tends to be higher, while it tends to be lower during times of recession or financial turmoil.
How Has the Prime Rate Changed Over Time?
Prime rates fluctuate over time depending on the movement of the federal funds rate, which reflects the state of the economy. The most recent prime rate history has been:
- 12/2023: 8.50%
- 11/2023: 8.50%
- 10/2023: 8.50%
- 09/2023: 8.50%
- 08/2023: 8.50%
- 07/27/2023: 8.50%
- 05/04/2023: 8.25%
- 03/23/2023: 8.00%
- 02/02/2023: 7.75%
- 12/14/2022: 7.50%
- 11/03/2022: 7.00%
- 09/22/2022: 6.25%
- 07/28/2022: 5.50%
- 06/16/2022: 4.75%
- 05/05/2022: 4.00%
- 03/17/2022: 3.50%
- 03/16/2020: 3.25%
Loans Unaffected by Changes to the Prime Rate
Any existing loan or line of credit with a fixed interest rate is not affected by a change in the prime rate. This includes student loans, mortgages, savings accounts, and credit cards that have fixed rates rather than variable rates.
Decoding Changes in the Prime Rate
A significant change in the prime rate often signals that the Federal Reserve has altered the federal funds rate. The Federal Reserve increases the federal funds rate to combat inflation and decreases it to encourage economic growth.
The goal of the Federal Reserve is to influence borrowing by businesses and consumers. Higher rates discourage borrowing, while lower rates encourage it.
The Record-High Prime Rate in the United States
The highest prime rate ever recorded in the U.S. was 21.5%, reached in December 1980.
The Bottom Line
The prime rate is the interest rate that commercial banks charge creditworthy customers and is based on the Federal Reserve’s federal funds overnight rate. Banks generally use fed funds + 3 to determine the current prime rate. The rate forms the basis for other interest rates, including those for mortgages, small business loans, and personal loans.
Related Terms: Federal Funds Rate, annual percentage rate (APR), prime lending rate.
References
- The Wall Street Journal. “Money Rates”.
- Federal Reserve Bank of New York. “Effective Federal Funds Rate”.
- Board of Governors of the Federal Reserve System. “Federal Reserve issues FOMC statement”.
- Federal Reserve Board. “FAQs: What Is the Prime Rate, and Does the Federal Reserve Set the Prime Rate?”
- Federal Reserve Board. “About the FOMC”.
- Federal Reserve Board. “July 26, 2023, Federal Reserve Issues FOMC Statement”.
- Federal Reserve Bank of St. Louis, FRED. “Bank Prime Loan Rate Changes: Historical Dates of Changes and Rates (PRIME)”.
- Casaplorer. “Prime Rates from 1955 to February 2024”.
- Bank of America, Newsroom. “Prime Rate Information”.
