Why The Current Prime Rate Matters When Getting A Loan

Why are interest rates the way they are? If a lender provides money to a borrower for a time, that means the lender can no longer spend that money. There is also a risk that he won’t be repaid. An interest rate is a compensation both for the loss of spending and for default risk.

But how much compensation is “right?” This depends on the length of the loan and the risk of the borrower. Compared to what? Fortunately, there is a baseline: the interest rate banks charge the least risky borrowers (prime borrowers), e.g., healthy corporations. This is called the prime lending rate.

What Is The Lending Rate Based On?

This baseline has an even more fundamental baseline, called the federal funds rate. This rate is set by the Federal Reserve (“Fed”), currently led by Chairman Jerome Powell. This is the interest charged when major banks with surplus funds lend to other major banks that need the funds, usually on an overnight basis. The banks are required by law to have a certain percentage of funds on reserve to protect against bank failures. But this reserve money earns no interest. So banks try to stick to that level, never below and not too far above. Consequently, banks pass money back and forth to earth other.

The Fed tries to tweak the federal funds rate to maximize economic growth and minimize inflation. If the economy becomes overheated, the Fed may increase the rate to slow borrowing and inflation. During the pandemic with economic contraction, the Fed lowered the rate from 0%–0.25%, the latter where it is now.

Where Are The Rates Historically?

The prime lending rate tends to be about 3% higher than the federal funds rate. So when the Fed lowered the rate to 0.25% in March 2020 in response to the pandemic, major banks—starting with Chase and M&T—reduced the prime rate from 4.25%  to 3.25%. No law requires banks to lend at 3% above the prime rate, but market competition means they are all pretty similar.

It’s likely that the federal funds rate, and thus the prime lending rate, won’t move too much in the next year or two. But they don’t always stay low. For example, from December 2015 to December 2018, they gradually increased from 3.50% to 5.50%. Since then, they have come down to their current level of 3.25%, a gradual reduction except for the pandemic drop of 1% in March last year.

What Does This Mean For Mortgage?

Since all other lending rates depend on the prime rates, it means they are likely at historic lows. This includes mortgages, credit cards, personal loans, home equity lines of credit (HELOC). For example, a HELOC might be “prime + 1%”, so 4.25% at current rates. A borrower with a high credit score might be eligible for a credit card of “prime + 9.99%”, but a riskier borrower may only be able to obtain “prime + 11.49%”. Many adjustable-rate mortgages (ARMs) are also tied to the prime rate.

It is trickier with long-term mortgages because they don’t always follow the prime rate. To illustrate, 30-year mortgage rates dropped from December 2016 to December 2017, although the prime rate increased from 3.75% to 4.50%.

All the other principles of lending and borrowing are still operating. Borrowers should still try to gain a good credit score, especially by paying bills on time. High-risk borrowers should still expect to pay higher rates than low-risk borrowers.