Lurking in the fine print of every loan and credit card agreement is the interest rate. How do lenders come up with that rate? It’s not magic: It comes from the prime rate. This bellwether interest rate is not available to consumers, but it almost always is a major factor in determining the interest that consumers pay for balances on credit cards, personal loans and other types of debt.
An overview of the prime interest rate
The prime rate is what a bank charges its very best, lowest-risk business customers. That ripples through to consumers in two ways, explained Marc Balcer, director of investment strategy with wealth management firm Girard. If you are borrowing money short term through a credit card or personal loan, the prime rate will drive those rates.
Conversely, if you are saving money in a short-term instrument like a certificate of deposit (CD) or money market fund, the interest rate you are paid by the bank also will track with the prime rate. “Money market rates are close to federal fund rates,” noted Balcer.
How the prime interest rate is determined
The prime rate is largely set by the rate that the Federal Reserve influences for its overnight lending to banks, explained Timothy Michael, associate professor of finance with the University of Houston-Clear Lake and executive director of the Financial Education Association. The fed funds rate is announced daily. And while the Federal Reserve cannot require banks to follow its lead, they do — and they look to each other to make sure that their rates are in line.
“If the Fed wants the rates to rise, they’ll manipulate some short-term mechanisms to use their influence,” said Michael. For instance, the Fed might hold back some of its own transactions to tighten the market.
Banks then figure how to charge their very best business customers based on the fed funds rate, usually described in terms of “prime plus.” For instance, if the fed funds rate is 5%, roughly where it was in early 2024, a lender might calculate its prime rate as 8%: the prime rate plus three percentage points.
Economic factors influencing the prime rate
“The most important link economically for the prime rate is inflation,” said Michael. The prime rate usually is quick to reflect inflation or, in the opposite direction, deflation.
While the prime rate itself is for banks lending to businesses, the fact that the prime rate quickly ripples through to credit card and short-term consumer debt makes it a good inflation indicator to watch.
Historical review of prime rate changes
If you’re wondering how to respond when someone complains about the current cost of borrowing, send them to the Federal Reserve Bank of St. Louis to see a running tally of the federal funds effective rate. There, you will see that from the aftermath of the financial crisis in 2009 until 2015, the federal funds effective rate scraped along in a range between 0% and 0.25%. Then, between 2015 and 2018, the rate bumped up to about 2.5%. When the Covid-19 pandemic hit in 2020, the Fed dropped the rate again to nearly zero, partly to remove pressure from a shocked economy. Then, as the US economy started to recover, the Fed raised its funds rate again, and it rose like a cobra to its current level of about 5.5%.
The federal funds rate and the prime rate
The fed fund rate sets in motion the daily juggle of Fed-to-bank lending that quickly translates to the prime rate, which banks charge their most valued and reliable commercial customers. The fed funds rate does not dictate the prime rate. The prime rate is formulated and charged by banks, although it tends to track changes in the fed fund effective rate, as you can see in the following chart:
Impact of the prime rate on individuals and the economy
When the prime rate changes significantly, consumer rates — for both loans and investments — will soon follow.
“If you are going to get a credit card, know that nearly all cards are tied to the prime rate,” said Michael. That’s why it’s important to understand when, why and how much your credit card rates will likely change, following the prime rate.
On the flip side, it takes banks and credit unions a bit longer to raise the interest rates that they pay on CDs and money market funds, even when the prime rate is rising. “There’s a noticeable lag,” said Michael. “The bank doesn’t want to pay you more money. Even though rates are going up, they do it slowly.”
How does the prime rate impact you?
Mainly, the prime rate is an early warning of changes in interest rates that are about to filter through to short-term loans and short-term lending.
Long-term loans, especially mortgages, are not much affected by the short-term fluctuations of the fed funds rate and the prime rates, said Balcer. In the same way, these short-term interest rates have little effect on long-term investable debt, such as bond rates, he said.
Frequently asked questions (FAQs)
Because the fed funds rate is set fresh each day, the prime rate theoretically also can change daily. But in practice, it takes a few weeks for even an abrupt rise in the prime rate to emerge, because even a dramatic change in the fed funds rate comes in several steps, not in a single big jump.
“Pretty nearly,” said Balcer, because all banks take their cues from the fed funds rate. Banks also consider competitors’ rates, but the variation in the prime rate is usually minimal.
Bear in mind that the prime rate is not available to consumers. Banks and lenders are very competitive when it comes to credit card and loan rates and, on the earning side, CD and money market rates. Always shop around for the best rates, whether you are borrowing or investing.
The prime rate is the commercial extension, in practical terms, of the daily interest rate set by the Federal Reserve. The prime rate sets the terms for the best-case borrowing scenario: What would the most reliable corporate borrower pay? All other rates, including consumer rates, are compared to the best-case rate.
The prime rate has little real-life relationship to mortgage rates, explained Michael, for two reasons. First, mortgages are collateralized by the house that is mortgaged. If the homeowner fails to pay the loan, the lender can repossess the house and sell it to get their money back. That’s not the case with, say, credit card debt. It is impossible to repossess the meal you paid for with your credit card. Secondly, mortgages are very long term. The standard mortgage is for 30 years — beyond the reach of even the Federal Reserve and its forecasts.