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The Prime Rate And Its Impact On Your Mortgage

6-Minute Read
Published on May 20, 2022
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If you've been following the financial news lately, all you've likely seen is that interest rates are going up for all sorts of loans and credit lines, including mortgages. But you may wonder how banks individually set their rates. After all, not every bank has the same rate. There wouldn't be much competition otherwise. Today, we’ll discuss the prime rate and how it affects mortgage rates.

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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 (those they judge to be the least risky). It’s usually reserved for corporate clients, with all consumers getting a slightly higher rate based on the prime rate.

When it comes to mortgages, the prime rate is often the benchmark for adjustable-rate loans. Lenders quote the rate using a benchmark. If they don’t use their own prime rate, there are a couple of commonly used alternatives. The benchmark for conforming loans used to be LIBOR (London Interbank Offered Rate), but today banks use other rates, including the SOFR (Secured Overnight Financing Rate), prime rate and treasury bill rates.

How Is The Prime Rate Determined?

Each bank sets its own prime rate, so there isn’t just one throughout the entire industry. They have to balance a profit motive with a need for their rate to be competitive in the market.

Banks usually base their prime rate on the federal funds rate, adding a margin. 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. According to the Journal, this represents the base rate posted by at least 70% of the nation’s 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 better rate that’s closer to the prime rate.

What Is The Current Prime Rate?

Because the federal funds rate has recently been on an upward trajectory, prime rates have been on the rise at banks across the country in recent months. To understand why this is the case, it helps to understand something about inflation. After all, the federal funds rate increases with the express purpose of controlling price increases.

Where the 1970s had a variety of factors that led to the historic high of 21.5% in 1980, 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.

For a little while now, inflation has been on the rise for a variety of reasons including supply chain disruptions and the aftereffect of stimulus related to COVID-19. The fallout from Russia’s war on Ukraine has caused oil and gas prices to spike. According to the federal government’s most recent print, the Consumer Price Index was up 8.3% compared to the same time a year ago. The Fed’s long-term target for inflation is 2%.

As of May 12, 2022, the prime rate reported by the Wall Street Journal was 4%. For a point of comparison, that’s up from 3.25% earlier this year, rising in tandem with the federal funds rate.

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How Does The Prime Interest Rate Affect Mortgage Rates?

The prime rate is the bare minimum rate a bank would charge if you took out a loan. 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, the higher the rate a lender will charge. The type of borrowing also matters. The rate for a mortgage would be different from one for a personal loan or credit card.

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.

Fixed-Rate

The only impact the prime rate might have on a fixed-rate mortgage is in terms of the return investors expect. If you lock in a fixed mortgage rate with a lender, this is one instance where the prime rate is often likely to have nothing to do with the rate you receive as a consumer. To understand why, let's run through a (quick) explanation of the way the mortgage market usually works.

When you originate a mortgage, lenders don’t usually hold that loan until it’s paid off. Typically, they sell it to one of the major mortgage investors. (You’re likely at least familiar with the names Fannie Mae, Freddie Mac, FHA, etc.) This allows them to get cash relatively quickly to make more loans to other clients.

When a new loan meets their requirements, one of these agencies will buy that loan and package it into something called a mortgage-backed security (MBS). These are groups of mortgages, as many as a thousand or more, that have similar characteristics and are sold to investors. As one example, there might be an MBS of conventional loans with 20% down payments and 750 median FICO® Scores.

Generally, the better your qualifications, the lower your rate can be because an investor will trade a lower return for lower risk. However, there is also a market component to this as well.

Mortgages are sold on the bond market. The attractive part of bonds for investors is that they offer a guaranteed rate of return. However, there are two downsides: First, if inflation increases at a higher rate than the rate of return you’re getting, you will lose money. Second, they don’t offer the yield that comes with higher risk investments like stocks.

In general, if people are feeling confident about the economy, they tend to invest more in stocks and less in bonds. If they see a downturn in the future, just the opposite is true. So, both the market and your finances impact the fixed rate for a mortgage. However, the prime rate has nothing to do with it.

Adjustable-Rate

ARM rates or adjustable rates have two phases. The introductory phase has a lower interest rate that’s set the same way a fixed-rate mortgage would be. Lenders call this the teaser rate because it lasts for the first part of the loan, usually 1 – 10 years.

After the introductory period, the rate adjusts. This is when the prime rate benchmark may come into play. The lender will create a margin and benchmark rate. The margin is the amount they’ll add to the benchmark.

ARM rates adjust according to the terms of your loan, so you’ll always pay the margin plus the prime rate or whichever benchmark the lender chooses.

Most adjustable-rate loans adjust every 6 months to a year, but their fixed period varies. For example, a 5/1 ARM has a fixed rate for 5 years and then adjusts annually for the remainder of the term. A 7/6 ARM, on the other hand, has a fixed rate for 7 years and then adjusts every 6 months.

The Bottom Line

The prime rate is the rate that banks give their most creditworthy clients, the least risky they have. Nearly every other consumer interest rate a bank has is based on this. However, mortgages are a special focus because these rates have much more to do with movements in the bond market. The one exception would be if your ARM had the prime rate as a basis for adjustment.

Now that you understand more about the way rates are set, you can consider yourself an informed and prepared mortgage shopper. You can apply for mortgage or call us at (833) 230-4553.

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Kevin Graham

Kevin Graham is a Senior Blog Writer for Rocket Companies. He specializes in economics, mortgage qualification and personal finance topics. As someone with cerebral palsy spastic quadriplegia that requires the use of a wheelchair, he also takes on articles around modifying your home for physical challenges and smart home tech. Kevin has a BA in Journalism from Oakland University. Prior to joining Rocket Mortgage, he freelanced for various newspapers in the Metro Detroit area.