What Is the Prime Rate and Why Is It Important?
If you studied macro-economics in high school or college, then you might remember hearing about the “prime rate.” However, this relatively obscure economic term can affect nearly all Americans who use credit cards or borrow money in other ways.
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What Is the Prime Rate?
The prime rate is the interest rate that commercial banks charge their best customers, typically large corporations. However, it’s also the best interest rate available to non-banks. Sometimes the prime rate is called the prime lending rate or it’s often referred to as just “prime.”
The prime rate itself is based on the federal funds target rate, which is the rate that banks charge each other for overnight loans in order to meet their Federal Reserve requirements each night. The rule of thumb is that the prime rate is three percentage points higher than the federal funds rate.
The federal funds rate is set by the Federal Open Market Committee, and every time it changes the federal funds rate, the prime rate rises or falls by the same amount.
Why It’s Important
Nearly all credit cards, including the Discover card, base their standard interest rates for purchases and balance transfers on the prime rate. The standard interest rates, or ranges of rates, are based on the prime rate, plus an additional value. Almost all credit cards in the United States use these kind of variable rates that will rise and fall with the prime rate.
When the Federal Open Market Committee decides to increase or decrease the federal funds rate, the prime rate will immediately change. When that happens, so will the interest rates of all of the credit card accounts issued in the United States that have variable interest rates.
These changes to your interest rate can increase or decrease your credit card account’s minimum payment, as well as the amount of your payment that goes toward paying your principal or interest charges. Other loans that can be affected by changes to the prime rate include mortgages, car loans and student loans with adjustable rates.
A Recent History of the Prime Rate
The prime rate has a history of fluctuating wildly, but it’s been fairly stable in recent years. For example, during a brief period in 1980, the prime rate soared to 21%, but it gradually fell to below 10% by 1985. Since 2007, the prime rate has been below 8% and it remained at a record low rate of 3.25% for a period of seven years starting in December of 2008. As of December 14, 2017, the prime rate is 4.50%.
What This Means to You
If you carry a balance on your credit cards, then you have to be prepared for unexpected changes to the prime rate, which is outside of your control or that of your credit card issuer. This is one of several reasons why you should always be careful to minimize the size of your credit card balances and make sure that you can easily afford to make your minimum payment, even if a rise in the prime rate means that your interest rates and minimum payment will rise. Unfortunately, you always have to assume that your variable interest rates can change at any time.
By understanding what the prime rate is, and how it can affect your accounts, you can make the best decisions for your finances.
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