The Federal Reserve recently raised the federal funds rate for the second time in a few months. The Fed seems to be fairly confident about the direction that the economy is moving in. That means more rate hikes are likely to occur in the near future. Interest rate hikes affect consumers in different ways. For example, they tend to cause the prime interest rate to rise, which affects credit card and short-term loan interest rates. Here’s everything you need to know about the prime interest rate and why it matters.
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The Prime Interest Rate: The Basics
Can’t remember how interest rates work? Interest is the fee that lenders charge in exchange for letting others borrow a portion of their funds. The kind of interest rates that borrowers qualify for can vary depending on their payment history, their credit scores and how much debt they’re carrying. Those with bad credit and questionable financial backgrounds usually get stuck with the highest interest rates. That’s because lenders take on more risk by giving those kinds of borrowers access to financing.
There’s more than one type of interest rate. The prime interest rate is what banks use when extending loans to their most valuable clients with the best track records and excellent credit scores. It’s a short-term interest rate that affects borrowing costs. While the Federal Reserve has no control over it, the prime interest rate is usually pegged to the federal funds rate (or the rate at which banks and credit unions lend funds to other financial institutions through overnight transactions).
The prime rate that most people are familiar with is the U.S. prime rate. The Wall Street Journal sets it based on the rate used by three-quarters of the biggest banks.
How the Prime Interest Rate Affects Borrowers
Consumers should care about the prime interest rate because most lenders, banks and credit unions use it as a benchmark. Mortgage lenders, for example, tend to refer to the prime rate when setting interest rates for borrowers with home equity lines of credit. The prime interest rate also comes into play when deciding what to charge individuals applying for personal loans, car loans, small business loans and private student loans.
Banks by law aren’t required to adjust their prime interest rate based on what’s happening with the federal funds rate. But many of them do it anyway. Of course, different banks can use a different prime rate or basis for their own interest rates.
When multiple financial institutions use the prime rate as an index, it’s easier for borrowers to compare loans, rates and terms. When the Fed hikes interest rates, consumers can expect the prime interest rate to rise, too, possibly by the same amount. Conversely, when the Federal Reserve lowers the federal funds rate, borrowers can expect to save some money on their monthly loan payments since they may owe less interest.
Corporations rather than individuals normally qualify for the prime interest rate. Everyone else’s interest rate is typically either higher or lower than the prime rate. You may see your interest rate expressed as the prime rate plus a certain percentage. That’s not necessarily the case with online lenders who often ignore the prime interest rate.
Credit Card Interest and the Prime Interest Rate
Credit card interest rates – particularly variable rates – generally rise and fall along with the prime interest rate. When the prime rate increases, the amount of interest you owe on your unpaid balances will likely increase. Let’s say that your credit card annual percentage rate (APR) is equal to the prime rate plus 15%. If the prime rate is 4%, your interest rate would be 19%.
Concerned about paying more interest when the prime rate goes up? You can stop thinking about your APR altogether if you pay your balance in full each time you make a credit card payment. Transferring your credit card balances to a card with a low interest rate or a 0% interest promotion could be a good idea if you’re trying to consolidate debt and avoid wasting money on interest. Switching to a credit card with a fixed-interest rate or getting your card issuer to put a cap on your variable interest rate might also be helpful if you’re trying to get rid of your credit card debt.
Those who pose the least amount of risk to lenders (i.e. corporations) are usually eligible for the prime interest rate. Even though individual consumers rarely have access to the prime interest rate, it should still mean something to you since it affects the cost of taking on a short-term loan and using a credit card. If you can’t remember anything else about the prime interest rate, remember that it typically moves in the same direction as the federal funds rate managed by the Federal Reserve.
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