If you’ve ever applied for a line of credit, you know you’re likely to see a wide variety of rates. These are set by the bank or lending institution you work with. But how do they set their rates? Is it something that’s pulled out of thin air? Not really.
In this post, we’ll talk about something called the prime rate and its application to a number of different consumer interest rates for various financial products including lines of credit, car loans and even mortgages.
What Is Prime Rate?
The prime rate is a rate the lending institution will give its most creditworthy clients and represents the best possible rate they’re willing to give. It’s not really meant for consumers, so even if you have an 850 FICO® Score, you’re not likely to get it. This interest rate is meant for corporate clients whose credit is in the best possible shape.
By way of example, let’s suppose Apple came into the bank and said they want to build a $250 million laptop factory in Tucson and they said, “We have the cash to cover this, but we would rather not tie up so many dollars in one investment all at once and we have a $25 million down payment.” In this purely hypothetical scenario, they might get the prime rate.
That’s not to say that the prime rate doesn’t affect consumer interest rates at all. The prime rate may always be a baseline factor in the way the bank prices things. For example, if you’re getting a home equity line of credit, it’s common for the rate to be based on the prime rate and a given margin. Your credit card interest rate is also based upon a prime rate tied to a margin.
In addition to the prime rate, there are other rates that are intended specifically for bank borrowing but that have an influence on consumer rates. These include the federal funds rate. The fed funds rate is the rate at which banks loan money to each other overnight. This rate is set by the Federal Reserve through its Federal Open Market Committee. Banks may use the federal funds rate as a base for setting their own prime rate.
There are other interest rates in which the prime rate may serve as a base, but other factors also play a role. For instance, the prime rate may play a role in your mortgage rates. However, if you have an adjustable rate mortgage (ARM), adjustments may be tied to another index like the London Interbank Offered Rate (LIBOR). LIBOR is being phased out, to be replaced by the Secure Overnight Financing Rate (SOFR). Still other ARMs may have adjustments tied to a Cost of Funds Index (COFI) or a Constant Maturity Treasury (CMT).
How Is The Prime Rate Determined?
Individual banks set the prime rate they are willing to lend funds based on. There is no regulation of this, per se. For these banks, you want to build in enough profit to be able to continue to operate, but you’re also constrained by competition because you don’t want to lose a qualified client to another lender.
When it comes to setting their prime rates, banks tend to take their cue from the federal funds rate and build in any costs and profit margin from there. The prime rate could theoretically adjust at any point. In practice, however, prime rates only adjust when a key benchmark like the federal funds rate (or whatever else a lender might choose to base their rates on) has a move. In a time when policymakers are actively making changes on a regular basis, this could change several times a year. At other points, the prime rate for an individual bank may go years without significant changes.
What Is The Current Prime Rate?
Because the prime rate for individual banks isn’t available for consumers, it’s generally not reported on an individual basis. However, an aggregate of prime rates is often used to set rates for credit cards and other items that are based on variable rates.
The most commonly used prime rate aggregate index is reported by the Wall Street Journal. It’s reported on a weekly basis.
Variable And Adjustable Interest Rates
There are two types of rates which would possibly see adjustments based on prime rates: variable and adjustable rates. On the surface, it sounds like these mean the same thing, so let’s go over the differences and when each might apply.
Variable rates can change as often as daily or weekly based on movements in the market. These are rates that are often most directly associated with credit cards and other revolving debt accounts like HELOCs.
Adjustable rates are most commonly referred to when it comes to mortgages. An adjustable rate mortgage (ARM) has an interest rate that stays fixed for a period of time at the beginning of the loan. Once that time frame is up, it adjusts, typically once a year for the remainder of the term. ARMs may be adjusted by adding the prime rate to a margin, but most commonly, other indexes like LIBOR, SOFR and CMT are used. However, these indexes themselves may in turn be influenced by the prime rate.
How To Qualify For The Prime Rate
As we mentioned a minute ago, the prime rate isn’t really meant for individual consumers, so you won’t get it if you’re not a well-capitalized company. However, that doesn’t mean there aren’t things you can do to help you secure the best possible interest rate and be the consumer equivalent of a prime client.
All lending is an exercise in making smart decisions with money by accounting for relative levels of risk. If you’re a low-risk borrower, that can make you a good candidate to get the best possible interest rates. How do you demonstrate that?
One of the first things any lender will look at in determining your qualifications is your credit score. The higher it is, the better your chance at being approved for the loan and qualifying for better rates. The length of your credit history also matters because the longer you can show positive credit behaviors like making payments on time, carrying little or no credit card balance month-to-month and only applying for the credit and loans that you need, the better.
Another thing that will help your approval chances, and in some cases your interest rate, is keeping a relatively modest debt-to-income ratio (DTI). If not too much of your income is going toward payments on existing debt every month, lenders realize that you’ll have more income to handle the payments on another loan or line of credit. Finally, when it comes to installment loans for things like a car or a mortgage, the bigger the down payment, the better your rate generally is. If you put more down up front, it shows commitment, and there’s always less risk for the lender associated with a smaller loan amount.
The Bottom Line
The prime rate is the lowest interest rate a bank is willing to do a loan or line of credit at. This rate is reserved for the most well-qualified clients, typically well-capitalized companies and corporations. The prime rate isn’t something advertised to individuals. Each bank sets its own prime rates, which are tied to other major borrowing rates like the Fed funds rate, with the institution’s desired profit margin added in. Because the rate isn’t consumer-facing, banks don’t publicize their prime rates. However, rates for things like credit cards and home equity lines of credit are based on an aggregate of prime rates from many major banks, like the one reported weekly by the Wall Street Journal.
Prime rates are typically associated with credit cards and other revolving credit lines. ARMs and some other loans that adjust periodically are based on other indexes which may or may not be influenced or in some way derived from the prime rate. While consumers can’t get access to the prime rate, good credit habits, among other things, will help you get the best rate possible.
Now that you know a little bit more about how banks determine interest rates, use that knowledge. If you’re ready to purchase a home or refinance your current mortgage, you can get started online. Feel free to give us a call at (833) 230-4553.
For further information on the inner workings of loans and lines of credit, check out the rest of the Quicken Loans® Learning Center.