The Prime Rate And Its Impact On Your Mortgage
Interest rates are always the number one concern when taking out a new loan, but what affects interest rates, and who sets them?
The prime rate is the basis of all interest rates. It’s essential to understand how it works, how it affects the interest rates you get and when it might change.
What Is The Prime Rate?
The prime rate, otherwise known as the prime interest rate or prime lending rate, is the rate banks give their best clients (aka least risky clients). It’s usually reserved for corporate clients, with all consumers getting a slightly higher rate based on the prime rate. Most lenders, for example, quote a rate of prime plus a specific margin.
Who Sets The Prime Rate?
Each bank sets its own prime rate, so there isn’t one prime rate throughout the entire industry. Banks set their prime rate based on the federal funds rate. The federal funds rate is the only rate that the U.S. Federal Reserve sets itself.
If you read the Wall Street Journal daily, you’ve likely noticed the prime rate they mention each day. This is usually an average of the prime rates set by the largest banks.
Why Is The Prime Rate Important?
The prime rate is the starting point for most interest rates in the lending marketplace. Most lenders don’t quote the prime rate for consumer borrowers. Instead, they quote the prime rate plus a specific margin based on the borrower’s creditworthiness and risk of default.
A borrower with risky qualifying factors, for example, will get a higher margin than a borrower with perfect credit and a low debt ratio. A borrower with good credit may be more likely to get a rate closer to the prime rate.
How Does The Prime Rate Work As A Benchmark?
The prime rate is often the benchmark for adjustable-rate loans. Lenders quote the rate using a benchmark. The benchmark used to be LIBOR, but today banks use other rates, including the SOFR (Secured Financing Overnight Rate), prime rate, and treasury bill rates.
How Does The Prime Rate Affect My Mortgage Rate?
The prime rate is the bare minimum rate a bank would charge if you took out a mortgage. Because most banks charge more than the prime rate for consumer credit, you’ll likely pay a marked-up version of the prime rate.
The size of the markup depends on the amount of risk you display. The higher your risk of default is, the higher the rate a lender will charge.
The prime rate affects all loans lenders give, including business credit. Business clients usually pose a lower risk of default, so they stand a higher chance of getting the prime rate or close to it.
The fixed-rate you lock in with a lender will be the prime rate adjusted to your level of creditworthiness. If you’re at low risk of default, your locked-in rate will be closer to the prime rate. If you’re a higher-risk borrower, your interest rate will be higher than the prime rate.
ARM rates or adjustable rates have two phases. The introductory phase has a lower interest rate that’s closer to prime. Lenders call this the teaser rate because it lasts for the first part of the loan, usually 1 to 10 years.
After the introductory period, the rate adjusts. This is when the prime rate benchmark comes into play. The lender will create a margin and benchmark rate. The margin is the amount they’ll add to the benchmark, such as prime on your adjustment date.
ARM rates adjust annually, so you’ll always pay the margin plus the prime rate or whichever benchmark the lender chooses.
Most adjustable-rate loans adjust annually, but their fixed period varies. For example, a 3/1 ARM has a fixed rate for three years and then adjusts annually for the remainder of the term. A 10/1 ARM, on the other hand, has a fixed rate for ten years and then adjusts annually.
What Is The Current Prime Rate, And Is It High Or Low?
The prime rate is currently at its lowest rate in history1. Where the 1970s had a variety of factors that led to the historic high of 21.5% in 19802, today’s low rates are directly related to the Federal Reserve’s policies. The Fed’s dedication to prioritizing expansionary policies has kept interest rates at historic lows to encourage economic growth at the risk of inflation. As inflation rates rise, the Fed may consider using more contractionary policies, but they would do so at the risk of slowing the economy.
[Note that interest rates continue to be at historic lows1. Include a graph and discuss the economic conditions – 1970s stagflation2 – that led to its historic high of 21.5% on December 19, 1980. Explain that the Fed’s response to the pandemic economy has been to prioritize expansionary policies – like keeping interest rates at historic lows – over contractionary policies used to fight inflation.]
When And Why Does The Fed Raise Interest Rates?
One of the Fed’s two properties is to influence the amount of money circulating in the economy. They do this by playing with the Fed rate. In a recessionary period, the Fed decreases interest rates to encourage consumers to borrow money.
Conversely, when we are in an inflationary period, the Fed raises interest rates to cool down spending, so inflation settles down too.
The Fed rate doesn’t directly affect consumer rates, but it generally has some effect as banks can borrow money at higher or lower rates which influences the rates they charge to consumers.
Is The Prime Rate Headed Up Or Down?
The prime rate’s direction is likely the most debated and talked about topic today. Many experts predict rates will rise as we head into 2022, but the Fed states that inflationary pressures won’t be necessary quite yet.
The Bottom Line: Take Advantage Of Current Low Rates Before They Rise
The bottom line is that the prime rate could change at any time. No one can predict its future, but we do know that right now, the rates are at the lowest they’ve been in decades. If you’re considering a home purchase or refinance, act now while you can still get rock bottom rates.
It’s easy to apply for a mortgage or refinance, get approved, and get your loan closed before rates increase. Apply today!