The prime rate is one of the main factors banks use to determine interest rates on loans. If you’re in the market for a new variable rate mortgage or a personal loan, understanding the prime rate and how it works can give you a better grasp on how much you’ll pay and the best time to get a loan.
The prime rate is the interest rate banks charge their best customers for loans.
“Best in this sense are the borrowers with the least risk of default,” says Jeanette Garretty, Chief Economist & Managing Director at Robertson Stephens, a wealth management firm in San Francisco. It’s usually the lowest interest rate banks will charge and is a benchmark to determine interest rates for other products, like lines of credit, credit cards and small business loans.
But the prime rate is only one factor among several that determine how much you’ll pay for loans. Banks also take into account your creditworthiness—the more likely you are to pay them back, the lower the rate they would charge and vice versa.
Banks usually only charge the prime rate to large, corporate customers with lots of financial resources. That’s because they have more money and assets to pay the loans back. Since individual consumers do not have the same resources, banks typically charge them the prime rate plus a surcharge based on the product type they want. A credit card rate might be the prime rate plus 10%, for instance.
On the other end of the spectrum, a bank’s very best borrowers may be able to negotiate lower than the prime interest rate. This kind of negotiation happened more frequently in the 1980s, Garretty notes, when interest rates were much higher. Lenders would try to attract “blue chip” borrowers by offering interest rates lower than the prime rates.
How Does the Federal Funds Rate Impact the Prime Rate?
The federal funds rate is an interest range set by the Federal Reserve. The fed funds rate is the Fed’s recommendation for what banks should charge when they lend money to each other overnight to meet reserve requirements.
“There is a rule of thumb that the prime rate is “fed funds plus 3,” says Garretty. “When the Fed funds rate changes, one bank will usually take the lead and announce a change in that bank’s prime rate that same day.”
The prime rate moves only when the federal funds rate moves. “This is unlike other rates (LIBOR, treasuries), which move daily/weekly according to short term financial market (supply and demand) conditions,” says Garretty.
Once a bank changes its prime rate based on the new federal funds rate, it will then start adjusting rates for many of its other lending products in the same direction. And when the federal funds rate and prime rate go down, other rates fall too, making it less expensive to borrow.
Note that certain lending products, like fixed rate mortgages and some student loans, are based on measures like SOFR and are less tied to the movement of the prime rate.
What Is the Current Prime Rate?
As of Feb. 8, 2022, the current prime rate is 3.25% in the U.S., according to The Wall Street Journal’s Money Rates table, which lists the most common prime rates charged throughout the U.S. and in other countries by averaging out the prime rate from the 10 largest banks in each country.
The federal funds rate is currently 0.00% to 0.25%, so with that in mind, you can see how the “fed funds plus 3” rule of thumb plays out: 3 + 0.25% = 3.25%.
Each bank has the ability to set its own prime rate. Most base it off the national average listed under the WSJ prime rate, but some could charge more or less depending on their goals.
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