What is the Prime Rate?

The prime rate is like the pace car at a NASCAR race…

NASCAR race cars can go very fast, much faster than a pace car. But the pace car plays a vital role in setting the appropriate pace before the official start of the race, and slows down the pace during an accident. Likewise, the prime rate sets the base rate for banks to lend money to customers, and brings down lending rates during a recession.

A commercial bank charges the prime rate to its clients with highest credit scores when giving loans. Banks and other types of lenders use the prime rate to price products like a mortgage, loan, or credit card. The prime rate is usually the lowest interest rate for a loan; a lender typically adjusts that rate based on a borrower’s loan type and credit history.

When a customer pays the prime rate for borrowing money, their lender assumes the loan is low risk, and that the customer is likely to pay back the loan on time. As the risk in issuing a loan increases, a lender usually charges additional interest on top of the prime rate. Lenders use the prime rate to set the interest rate for a wide variety of loans, including credit cards, auto loans, business or personal loans, and lines of credit.

The prime rate is determined by the federal funds rate — The interest rate at which banks can borrow money from each other overnight to meet their minimum reserve requirement from the Federal Reserve.

While banks may issue loans to customers, they’re also required by law to keep a minimum amount of money on hand at the end of the day. The money kept on hand ensures that the individuals who deposited money at the bank will be able to withdraw it when they need.

Historically, the Federal Reserve has required banks and other depository institutions to hold at least 10% in reserves. To meet that minimum reserve requirement every day, banks may need to borrow money from each other overnight. Banks charge each other the federal funds rate for these overnight loans. In the week of April 14, 2020 (amid the Covid-19 pandemic), the federal funds rate was at a much lower 0.25%.

A bank typically sets their prime rate by adding a percentage on top of the federal funds rate. Historically, banks have added about 3% to the federal funds rate to establish their prime rate. For example, on April 14, 2020, the federal funds rate was 0.25%, and the prime rate was 3.25%. The Federal Reserve keeps track of the prime rate for the top 25 commercial banks by their domestic assets — Valuable items the bank owns within the country and reports on its balance sheet. Banks tend to set their prime rates together, meaning one bank won’t move its prime rate unless the rest follow suit.

One main factor that affects the federal funds rate is its target range, which is set by the Federal Reserve’s Federal Open Market Committee (FOMC). The FOMC consists of 12 members, including governors of the Federal Reserve, and presidents from the 12 Federal Reserve Banks, on a rotating basis. The committee meets eight times a year to review the economy and establish action steps (like setting the interest rate and the money supply) to achieve a desired economic outcome. They use a set of tools to achieve economic goals, which is collectively known as monetary policy.

The FOMC’s target range or the federal target rate was 0% to 0.25% as of March 16, 2020. Based on the FOMC’s guidance for the federal funds rate, the prime rate that week was 0.25%. Think of the FOMC’s guidance for the target federal funds rate as the first in a chain of dominos:

Guidance for the federal funds rate -----> Federal funds rate ------> Prime rate 0% to 0.25% 0.25% 3.25%

In addition to the FOMC’s guidance, additional monetary policy actions by the Fed can affect the federal funds rate. Here are a few examples:

• Determining the necessary level of cash reserves that banks need to keep on hand.
• Purchasing (or selling) short-term bonds to increase (or decrease) the available cash circulating in the economy.
• Providing forward guidance on the outlook of the economy and future monetary policy — Information used by banks, businesses, and individuals to make investment and other economic decisions.

The Federal Reserve may use one or all of its monetary policy steps to determine the federal funds rate.

The Federal Reserve releases the current prime rate each week under “Selected Interest Rates.” For example, on the week of April 14, 2020, the prime rate was 3.25%. The Wall Street Journal (WSJ) also reports a prime rate on a daily basis. However, the reported WSJ prime rate is the one reported by at least seven out the ten largest U.S. banks.

The prime rate is a dynamic interest rate, meaning it changes over time. For example, on April 14, 2020, the Wall Street Journal reported that the 52-week range for the prime rate had a high of 5.50% and a low of 3.25%. To give you a sense of how the prime rate has changed over time, let’s review the history of the annual prime rate every five years since 1960.

(Source: Federal Reserve)

Here’s a timeline of the annual prime rate since 1956. The gray labels mark periods of recession (when the national economy endures at least six months of declining economic growth). During a recession, the Federal Reserve typically reduces the prime rate to help stimulate the overall economy.

(Graph at https://www.dropbox.com/s/cimf74ct3xmudfx/Chart.png?dl=0)

The highest prime rate in history was on December 19, 1980, standing at a record-breaking 21.5%. The Federal Reserve set the federal funds rate guidance to sustain the 21.5% prime rate until January 1, 1981. By contrast, the lowest prime rate in history was set on March 16, 2020, at 3.25%. The last time the U.S. economy experienced a 3.25% prime rate was in 1955.

The prime rate provides lenders a base rate to establish pricing for all types of short-term loans, including credit cards, car loans, home equity loans, and student loans. Here are some examples of how lenders price their financial products based on the prime rate (all quoted rates are as of April 14, 2020):

• Credit cards: The issuer of Amazon’s credit card sets the annual interest rate of its credit card based on the prime rate and your creditworthiness, ranging from 14.24% to 22.24%.
• Small business loan: The Small Business Administration (SBA) charges eligible small businesses the prime rate plus 4.25% for 7(a) loans (main loan program from the SBA for providing financing to eligible small businesses) of $25,000 and under.
• Home equity line of credit: U.S. Bank prices its home equity line of credit (a revolving line of credit secured against the equity of your home) ranging from 3.25% to 7.5%, as of April 20, 2020.

The prime rate also has an indirect effect on fixed, long-term loans. For example, let’s say you secure a fixed 30-year mortgage (an agreement where you borrow money to buy a property that your lender can seize if you fail to pay back the loan in full within 30 years). The rate of these loan types are usually locked in (aka fixed) long term. Typically, you would have to apply for the refinancing of a fixed, long-term loan in order to take advantage of a lower interest rate.