Prime Interest Rate: How does the Federal Reserve calculate the Prime Rate?

Summary: Interest rates on all credit instruments are in some way tied to the prime rate. When is the best time to lock into an interest rate?

The most credit worthy customers of a bank qualify for its prime interest rate and only a small percentage of borrowers will be offered this rate. The rate is generally, but not always, the same at all banks. Since very few loan applicants will be offered the prime interest rate, why is it of interest to almost all borrowers? Most interest rates on all credit instruments are in some way tied to the prime rate thus making it of great importance to even the most challenged credit candidate.

Rates set by the Federal Reserve such as the Fed funds rate and the discount rate affect the prime interest rate, but the prime itself is not set by the Fed. The Fed funds rate is the rate at which Federal depository institutions lend money to each other on an immediate overnight basis. It can fluctuate on a daily basis. The discount rate is the rate charged by regional Federal Reserve banks when they lend money to depository institutions. Currently the Fed funds rate is about 4%, the discount rate is about 5% and the prime interest rate hovers around 7%.

Interest rates react to the prime rate and changes in the prime rate in a variety of ways. Adjustable rate mortgage loans and credit card interest rates change in a very specific manner. They go up if the rate goes up because they are directly tied to the prime rate as in “prime plus one” or “prime plus two” which means the rate will be the prime rate plus one point or two points. (Credit card rates may also adjust due to an individual’s payment habits or individual credit situations.)

Standard fifteen, twenty and thirty year mortgage loans have more complex relationships to the prime interest rate. Non-adjustable mortgage rates may often times be lower than the prime rate. This is because these rates are set by the secondary loan markets. These markets are made up of investors who buy and sell mortgage portfolios based upon where the best investment returns can be found.

On a day to day basis the complicated fluctuations of the credit markets may be of little interest to most people. However, when it’s time to make a major purchase it would be wise to monitor current interest rates and lock in a rate in when the prime interest rate seems to be about to turn upward.

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