When you get a loan or credit card at a commercial bank like Bank of America (BAC) or Citibank (C) , the lowest interest rate you could be charged is called the "prime rate." Although the prime rate may be something you vaguely recall from a previous economics course, it can affect your wallet today in very real ways.
And while you likely have heard of the federal funds rate, which is the rate at which the Federal Reserve lends funds to commercial banks, the prime rate may very well be considered the crème de la crème of interest rates for non-bank customers. But, what exactly is the prime rate, and how has it changed over the years? Better still, what is the 2018 prime rate?
What Is the Prime Rate?
The prime rate is the lowest interest rate available for non-banks to borrow money - similar to the federal funds rate that the Federal Reserve uses to loan banks funds. The prime rate (also called "prime lending rate," or even "prime") is the rate at which banks loan preferred customers funds for mortgages, loans and credit cards, and is the best rate customers can obtain. Currently, the prime rate sits at 5.25%.
Most banks adjust their prime rates at the same time and are generally uniform with one another - and, are most often adjusted in tandem with the federal funds rate, making it especially sensitive to Fed rate hikes.
The WSJ Prime Rate, which is frequently used as a benchmark of the current prime rate, is obtained by the Wall Street Journal surveying 30 major banks and re-calibrating the rate every time 3/4 of banks (or 23) change their rates. Because of its frequency, the WSJ Prime Rate is one of the most widely accepted current prime rates.
Because the prime rate is the best interest rate available by commercial banks to non-banks and customers, it is generally given to corporations that use commercial banks for loans or credit, or especially creditworthy customers (those with the highest credit scores) seeking credit cards or other loans from banks. So, the prime rate is the basis on which banks determine loaning or borrowing costs for many short-term products (including auto loans, mortgages and credit cards).
When the Federal Open Market Committee (FOMC) raises the federal funds rate, the prime rate follows. The prime rate is generally 3% higher than the federal funds rate (which is currently at 2.25%).
Prime Rate vs. Libor
While the prime rate applies to U.S. banks, international banks have their own kind of prime rate - called the London Interbank Offer Rate (or Libor). Unlike the prime rate, Libor is the rate at which fellow banks lend each other funds (typically short term). Most international banks (or banks with international clients) base their borrowing or lending rates off of Libor.
Still, the prime rate, federal funds rate and Libor generally move together - and the one-month Libor rate typically sits just above the federal funds rate.
However, historically, the three rates haven't always moved in tandem. In fact, when they are out of sync, the financial markets are typically indicating some kind of problem.
For example, Libor remained steady in September of 2007 even when the federal funds rate and the prime rate dropped, due to concerns over the risky subprime mortgage rates. In 2008, the prime rate dropped drastically to 4.5% alongside the Fed's lowered rate of 1.5%, while Libor remained surprisingly close to prime rates at 4.3% following panic on Wall Street.
Prime Rate and Variable Interest Rates
Most banks base their other interest rates (like adjustable-rate loans, variable interest rates, interest-only mortgages and credit card rates) on the prime rate.In general, rates for credit cards are variable, but are typically the prime rate plus a certain set percentage. While the prime rate may change, the variable rates usually change in parallel. And, because these rates are variable, they are often the most sensitive to Fed rate hikes.
Prime Rate and the Federal Reserve
While the prime rate is not determined by any government entity, it can be influenced by the Federal Reserve's prime rate - the federal funds rate.
Still, individual institutions and banks may or may not choose to change their prime rate, although most do so in tandem with each other.
However, the FOMC meets every six weeks or so, at which point it determines if changes to the federal funds rate need to be made. These changes generally do affect the prime rates that individual banks offer their customers. The general rule has been that the prime rate is about 3% above whatever the federal funds rate. Still, it is important to note that individual banks may offer rates below or above the prime rate, as it is not set in stone.
Who Qualifies for the Prime Rate?
Typically, the prime rate is only offered to highly-qualified individuals or large corporations who pose very little risk of defaulting on their loans. For example, an individual with a strong credit rating will generally be able to get the prime rate - or lowest rate - for their loans, including mortgages and credit cards.
Still, while the prime rate is more an index that determines the basis for borrowing costs and lending rates, it is generally the benchmark that is used for the best customers of commercial banks. So, if you've got a strong credit score, you're probably getting charged near the prime rate.
Historical Prime Rate
Historically, the prime rate has been as high as 11% in 1983, dropping to around 6% in 2008, and most recently dropping to sit at around 5.25% in 2018.
Additionally, when the prime rates are low, liquidity in the market is high due to the ease of lending and borrowing (stimulating the economy). Conversely, a high prime rate makes it harder to borrow and tends to slow economic activity.
Prime Rate 2018
As of October, 2018, the prime rate sits at 5.25%. That is up 0.25% from about a month ago, and 1% up from last year (4.25%).
But, how sensitive is the current prime rate to the recent Fed hikes?
Have Fed Rate Hikes Affected the Prime Rate?
President Trump certainly made his thoughts on the recent Fed rate hike clear.
"The Fed is making a mistake," Trump told reporters on Wednesday. "They're so tight. I think the Fed has gone crazy."
The Fed's new rate is up 0.25 points to now sit at 2.25, according to CNBC. In the wake of the hike, the Dow Jones Industrial Average (DOW) fell over 800 points, while the NASDAQ (NDAQ) dropped some 4%, with the S&P 500 ^GSPC followed suit by dropping as well. The rate hike is the eighth during Trump's presidency.
But, how is this most recent Fed rate hike going to affect prime rates?
Well, for credit card users with balances still on their cards, the subsequent changes in prime rates could affect user's interest rates on their cards (and thus, the amount of cash they're dealing with). Additionally, Fed hikes can affect mortgage rates as well. So, it can be very helpful to track the federal funds rate as well as prime rates frequently to ensure your pocketbook is prepared for changes.