Prime Rate
The prime rate, often referred to as the prime lending rate, is the benchmark interest rate that commercial banks charge their most creditworthy corporate customers, such as large, established corporations with pristine credit histories. It represents the most favorable borrowing rate available and serves as a fundamental index for setting interest rates on a wide range of consumer loan products, including mortgages.
Purpose and Determination
The prime rate is to establish a baseline for lending. By setting a rate for their lowest-risk borrowers, banks can then price other loans by adding a “spread” or “margin” to the prime rate, with the size of the margin depending on the perceived risk of the borrower and the specific loan product.
The prime rate is not set by a single entity, but is instead heavily influenced by the federal funds rate, which is the overnight lending rate that banks charge each other. The Federal Reserve’s Federal Open Market Committee (FOMC determines this rate). When the FOMC raises or lowers the federal funds rate to manage inflation and economic growth, major commercial banks almost immediately adjust their prime rates in lockstep. The most widely cited benchmark is the U.S. prime rate published by The Wall Street Journal, which is based on a survey of the nation’s largest banks.
Impact on Mortgage Rates
The prime rate has a direct and significant influence on certain types of home loans, while others are more indirect.
- Direct Impact on Variable-Rate Loans: The most direct connection is seen with home equity lines of credit (HELOCs) and certain Adjustable-Rate Mortgages (ARMs). The interest rates on these products are often calculated as “prime plus a margin.” For example, a HELOC might have a rate of “Prime + 1%.” When the prime rate increases, the interest rate on these loans adjusts upward at the next designated interval, leading to a higher monthly payment for the borrower.
- Indirect Impact on Fixed-Rate Mortgages: The relationship between the prime rate and fixed-rate mortgages is less direct. The interest rates on long-term, fixed-rate loans (like a 30-year mortgage) are more closely tied to the yields on long-term U.S. Treasury bonds. However, the economic conditions that cause the Federal Reserve to adjust the federal funds rate, and thus the prime rate, also influence investor sentiment and the bond market. Therefore, while not directly linked, changes in the prime rate often signal a broader shift in the interest rate environment that will eventually be reflected in fixed-rate mortgage costs.
Understanding the prime rate provides homeowners and buyers with valuable insight into the broader economic forces that shape the cost of borrowing, empowering them to make more informed financing decisions.
