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Prime rate determines the interest rate you pay for short-term loans such as credit cards, home equity lines of credit and adjustable rate mortgages. The fluctuation of the prime rate can help predict how consumers will spend money in the near future.
If you're shopping for a standard 15- or 30-year fixed-rate mortgage loan, you don't need to concern yourself too much with the prime rate. Mortgage rates are determined by other factors, such as the 10-year Treasury bond yield, mortgage-backed securities, and general economic activity.
But don't stop reading just yet... the prime rate will be of interest to you if you plan to get an adjustable rate mortgage (ARM), take out a home equity line of credit (HELOC), or apply for a credit card, personal loan, debt consolidation loan, or a business loan. Those loans are generally based off the prime rate.
The prime rate is the best rate commercial banks offer their best customers, typically corporations, for short-term loans. Different banks can have different prime rates. So the Wall Street Journal (WSJ) polls the 10 largest banks to find out what the lending rate is for each bank. It then averages the numbers to arrive at a prime rate. The WSJ then publishes this number, which is the reason the prime rate is often called the "Wall Street Journal (WSJ) prime rate." When seven or more of the 10 banks change their prime rate, the WSJ reflects the change. The prime rate is also called the "U.S. prime rate."
The 25 largest banks determine the prime rate. The rate is a reflection of another rate, the federal funds rate, which is set by the Federal Reserve. The federal funds rate is the interest rate banks charge each other for overnight loans. The prime rate usually runs about 3 percent higher than the federal funds rate.
When you wish to apply for a credit card, for example, the interest rate you pay will be based on the prime rate. Your creditworthiness, which is based on your credit score, is then added to the mix to determine your interest rate, which is prime plus whatever the lender adds.
If you carry a balance on your credit card, you should be very interested in keeping an eye on the prime rate. That advice goes for any other type of variable rate loan you might have, such as a HELOC or an ARM.
Although the prime rate might be low today - it's 3.25 percent at the time of publication - it has fluctuated greatly over the years, from a low of 1.75 percent in 1947 to a whopping, record-breaking high of 21.50 percent in 1980. As recently as 2006, the prime rate went as high as 8.25 percent. Sometimes the prime rate stays the same for years, as is what is currently the case - the prime rate has been 3.25 percent since December 2008 - but it could change every six weeks.
The prime rate serves as a benchmark, or measurement, to calculate interest rates used for various types of short-term loans. We've already mentioned that lenders often add a percentage to the prime rate based on your credit score. But lenders can also charge less than the prime rate for the best customers. If you have excellent credit and just financed a car loan deal for 1.5 percent, for example, your lender was acting on a promotion designed to get business by charging you less than the prime rate.
The prime rate doesn't have much of an effect on fixed-rate mortgage loans. Its use is mainly for short-term loans, of which 15- or 30-year mortgage loans are not short-term. However, the prime rate can indirectly affect mortgage loans. We mentioned earlier that one factor that could determine mortgage rates is the general economic condition of the country. And the prime rate is a good indicator of that because the prime rate is a reflection of the federal funds rate.
The Federal Reserve (Fed) sets the federal funds rate, raising or lowering it to help keep inflation under control. Inflation happens when goods and services cost more to buy than they did before. When the Fed raises the federal funds rate, the prime rate also increases. When that happens, interest rates tend to go up for all sorts of consumer loans, including mortgage loans, and as a result fewer people spend money. The opposite happens when the Fed lowers interest rates, which it tends to do during a slow economy to try to boost spending. Keep in mind, however, that the Fed does not set the prime rate, but banks may use the federal funds rate as a guideline when they determine their prime rate.
When the prime rate declines, consumer spending tends to rise. Consumers can feel more confident borrowing money when interest rates are low. Because a mortgage probably represents the biggest loan you'll ever have, you might be more likely to consider buying a home when the prime rate is low. If you have an adjustable rate mortgage, and you think interest rates will rise, you may want to consider refinancing to a fixed-rate loan to take advantage of the lower rate before it goes up. Note that there are no guarantees on whether rates will go up or down.
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