What is a prime rate?
You may have heard news headlines in recent years that talk about the U.S. Federal Reserve increasing (or decreasing) interest rates. But what does that mean, and how is it related to the prime rate?
The prime rate is a type of interest rate that is set by banks and lenders as a baseline for what APR they want to charge. We’ll unpack this in more detail below.
First, it’s important to understand the larger picture. When the Federal Reserve (the Fed) observes the macroeconomics of the U.S., it seeks to determine if the economy needs a boost, or a cool-down. If you start to see the prices of gas and groceries rise due to inflation, the Fed may decide to raise interest rates (otherwise known as the federal funds rate) — which makes it more expensive to borrow money and therefore helps to slow down those rising prices.
On the other hand, if a core economic factor such as unemployment begins to rise and it’s harder to find jobs, the Fed may choose to decrease interest rates — which makes it easier to borrow money or use a credit card because consumers and businesses will pay less interest on the life of their loan.
Taking into account these factors, lenders will set the prime rate. In this article, we’ll break down the following questions:
- How is prime rate determined?
- How do I find the current prime rate?
- How does prime rate affect credit cards?
How is a prime rate determined?
As mentioned above, the prime rate is set by banks and lenders, based on a number of factors. Lenders will look at the federal funds rate (set by the Fed) and typically add another 3% on top of that. So, if the federal funds rate is 4%, lenders may set prime at 7%. Your APR would be determined from there. The interest terms you get on a loan or credit card all depend on variable factors including prime rate — but also your credit score, income and more.
In short, the prime rate is influenced by the federal funds rate, but it is determined by individual banks and lenders and can change over time (even daily) with market conditions. When the Fed raises or lowers the federal funds rate, you will typically see the prime rate move correspondingly. Technically, the prime rate has no limit. It can be as high or as low as a lender would like it to be.
Consumers may want to stay aware of on-going economic trends as they will greatly influence how much it will cost them to borrow money — including credit card debt, mortgages, auto loans and business or personal loans. Some of these trends include the gross domestic product (GDP), inflation, unemployment, consumer spending and home real estate sales. These factors all provide insight into the health of the economy.
How to find the current prime rate
The prime rate changes frequently. You can see the most up-to-date rate in the Wall Street Journal’s Money Rates table, where all current interest rate information is published daily, both online and in print.
JP Morgan Chase & Co. also offers a historical summary of prime rate changes over the past several decades, including the most recent.
How does prime rate affect credit cards?
Most credit cards have a variable interest rate (or variable APR) based on the prime rate. So, if the prime rate fluctuates, the interest you accrue will consequently go up or down as well. This could make it harder or easier to pay off your debt. For example, a 0.50% increase in the prime rate could mean an additional $5.00 for every $1,000 you have in unpaid balances. The minimum payment you’re required to make each month may also vary depending on changes to prime.
Keep in mind that if you pay off your balance in full each month you won’t need to worry about the prime rate or APR. Interest rates only become relevant if you carry an outstanding balance or miss a payment.
Bottom line
The prime rate is used as a benchmark for banks to determine the interest rates they want to set for various kinds of loans, including credit cards. Economic conditions can cause the prime rate to increase or decrease. While you have no control over these macroeconomic conditions, you can work toward a healthy credit profile, which puts you in a good position to receive the most competitive rates.
