U.S. Prime Rate: Frequently Asked Questions (FAQ)

The U.S. Prime Rate has nothing to do with the rate you will get on a 15- or 30-year, fixed interest rate mortgage. Mortgages rates are determined by the buying and selling of mortgage securities by banks, investors and brokerage firms on Wall Street. The notion that the U.S. Prime Rate influences long-term mortgage rates is a common misconception.

Mortgage rates often track closely with the yield on the 10-year U.S. treasury note, but not always.

When investors feel that the long-term outlook for inflation is favorable, long-term mortgage rates tend to go down. Conversely, when investors believe that the long-term inflation outlook is unfavorable, then long-term mortgages rates tend to go up.

The U.S. Prime Rate is used by American financial institutions as an index for:

• Most variable-rate credit credits
• Most home equity lines of credit
• Most small and medium-sized business loans
• Most personal loans
• Certain variable-rate car loans
• Certain variable-rate education loans
• Certain debt consolidation loans
• Certain adjustable-rate mortgages

Prime Rate predictions based on the fed funds futures market are most accurate within 45 days of the next scheduled Federal Open Market Committee (FOMC) monetary policy meeting. In other words, as the next FOMC meeting approaches, forecasts based on the fed funds futures market get more and more accurate with each passing day.

If you want to know whether the U.S. Prime Rate is going to go up, down or stay where it is, then stay tuned to this blog for the latest Prime Rate forecast.

You may be wondering how other websites can predict where the Prime Rate will go 2, 5, or 10 years from now. The answer is: they can't. Why? Because there are too many economic variables that influence Federal Reserve decisions on short-term interest rates. How can anyone know where the unemployment rate or the Consumer Price Index (CPI) will be 5 or 10 years from now? No one can. Bottom line: making interest-rate predictions that far ahead in the future would be like offering a weather forecast for a date 5 years into the future. Unless one has a time machine, it simply can't be done.

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The Federal Reserve's Federal Open Market Committee (FOMC) convenes a monetary policy meeting eight times per year (about every six weeks.) The FOMC may also hold an emergency monetary policy meeting at any time, if economic conditions warrant.

The current FOMC monetary policy meeting schedule can be found at www.FOMC.tv.

When a U.S. bank needs to borrow funds on a short-term basis, it usually does so via the fed funds market, borrowing from another bank at a rate controlled by the Federal Reserve called the fed funds rate.

However, if a bank seeking funds can't find a lender via the fed funds market, it can borrow directly from the Fed, via the Federal Reserve's discount window facility. When a bank borrows directly from the Fed, the rate it pays for the funds is known as the discount rate.

The discount rate is actually an umbrella term for 3 separate discount window programs: the primary credit rate (for healthy banks), the secondary credit rate (for not-so-healthy banks) and the seasonal credit rate (for smaller banks with seasonal borrowing needs). The primary credit rate, which is often called the primary rate, has nothing to do with the U.S. Prime Rate, but consumers sometimes confuse the two.

The 3 percentage points that's tacked onto the fed funds rate exists to cover banks' cost of making loans, costs like performing credit checks, paying loan officers to talk with customers and process the loans, paying for legal paperwork, etc. The Prime Rate is essentially the break even rate of interest for banks making loans. To make money, banks will add a margin based primarily on the risk of the loan; the higher the risk, the greater the margin.

Banks are always looking for the cheapest source of funds. When you open a 12 month CD account at your local bank or credit union, you are in essence lending your money to the financial institution for 12 months. If your bank can borrow via the fed funds market, and pay 3.5%, then why would they pay you 7% or 8% on a CD?

NB: The fed funds money market is not just for overnight loans. Longer maturities can be negotiated between banks. Also, banks can borrow on an overnight basis repeatedly, day after day, as long as there are other banks willing to lend.

To understand how LIBOR works, click here.

The National Information Center of the United States Federal Reserve System maintains an official list of the 50 largest bank holding companies (BHC) in the Unites States, ranked by total assets, here.

Certain banks use rate floors to shield themselves in case the Prime Rate drops to a level these banks feel would render many of their loan and credit products unprofitable. Here is an example from the terms and conditions of an Advanta business credit card:

"...Your Variable Account Rate Index for any billing cycle will be chosen by us from among the Prime Rates published in The Wall Street Journal's "Money Rates" section during the three (3) months prior to the month which contains that cycle's Billing Cycle Closing Date, but will not be less than 5.00%..."

With this particular business credit card, any U.S. Prime Rate below 5.00% would be meaningless.

Yes, 3.25% is essentially the lowest the U.S. Prime Rate will go. The odds that Prime will ever go lower are extremely small.

On December 16, 2008, the Federal Open Market Committee (FOMC) of the Federal Reserve set a target range of 0% - 0.25% for the benchmark fed funds rate, which was the Fed's way of setting a "zero" rate. American banks responded by setting their Prime to 3.25%, in accordance with the Prime Rate rule of thumb: Prime = (fed funds target rate + 3). Since the Fed can't reduce short-term rates lower than zero, 3.25% is basically the lowest that Prime can go.

American banks have followed the Prime Rate rule of thumb since the second quarter of 1994, and, currently, there exists no indication that the relationship between the target fed funds rate and the U.S. Prime Rate is going to change any time soon.

Sovereign Debt Crisis & The US Prime Rate

If the United States government opts to default on the national debt, severe financial-market disruptions are likely to occur. The United States Prime Rate, however, would not be affected.

The US Prime Rate, which is currently at 3.25%, is as low as it can possibly go(¹). Therefore, it can't go any lower.

A default won't cause Prime to go any higher either. That's because the Federal Reserve isn't going to do anything to make any financial crisis -- including a Treasury Department default on its various bills, notes and bonds -- any worse than it has to be. It's 2011, and the Fed is still trying to counteract the effects of the 2008 financial crisis and subsequent Great Recession (high unemployment.) Raising short-term rates, including the US Prime Rate, in the current economic environment, would risk driving the economy back into recession.

The Fed controls Prime via the target fed funds rate: Prime = (target fed funds rate + 3).

However, the Fed does NOT have any direct control over mortgage rates. And since 30-year, fixed-rate mortgages track very closely with long-term Treasury yields, a government default would almost certainly cause mortgages rates to rise. Why? Because demand for government securities would decline rapidly as a result of the federal government's downgraded credit rating. With Treasury securities, yields rise as demand falls, and vice versa.

If the government defaults, it's likely that interest rates associated with car and student loans would also rise.

It's important to note that while Prime won't be affected by a government default, credit-card rates can still rise. Credit-card banks can't change the US Prime Rate, but they can modify the margin they add to Prime with their variable-rate loan products.

Most credit cards are indexed to Prime. If you look at a card's terms and conditions, you'll likely see the annual percentage rate (APR) defined as Prime + Margin. Example:

"...Your APR will be the WSJ Prime Rate + 9.99%..."

So a bank may respond to a government default by raising the margin -- the 9.99% -- to a higher figure.

If you're worried about the rates associated with the credit cards you already have open, here's the skinny: If your credit-card banks decides to raise your APR by raising the margin, you'll be able to reject the increase and close your account. If you close your account, you'll continue to make payments on the account until it's paid in full, and you'll be able to do so at the original rate you signed up for.

NB: Pay close attention to the mailings from your credit-card banks. You don't want to miss any notices about rate increases. If you do, and 45-days pass, you may end up with a "surprise" rate increase.

S&P Downgrade & The US Prime Rate

Friday, August 5, 2011: The credit rating for the United States (long-term debt) has been downgraded from AAA to AA+ by the ratings agency Standard & Poor's. This action by S&P may cause borrowing costs to rise for the federal government, and will likely produce some heartburn in a variety of domestic and international money markets. But it won't have any effect on the United States Prime Rate.

American banks are required to keep a certain amount of cash on reserve at the Fed. When necessary, banks can borrow cash from other banks on a short-term basis via the fed funds market. The Fed controls the rate banks pay for these loans via the fed funds target rate. The target fed funds rate, in turn, determines the US Prime Rate: Prime = (target fed funds rate + 3).

The Fed also determines the rate banks pay when they borrow money directly from the Federal Reserve (the discount rate.)

Government Borrowing via Treasurys vs. Banks Borrowing via The Fed

When the United States government needs to borrow money, the Treasury Department handles this by issuing Treasury bills, notes and bonds. Ratings agencies (Standard & Poor's, Fitch and Moody's) rate securities issued by governments all over the world, including those issued by the US Treasury Department. These agencies, however, do not rate any kind of borrowing done by banks via the Federal Reserve.

Banks borrowing via the Fed is a completely different animal than the government borrowing via Treasurys.

That's why the US Prime Rate won't be affected by a ratings downgrade by any agency: borrowing by banks to cover reserve requirements has nothing to do with the government borrowing via the Treasury Department.

Any financial-market turmoil caused by America's downgraded credit score may prompt banks to raise their lending rates, but Prime, currently at 3.25%, isn't going to rise or fall as a result. For more on this, please see the section on Sovereign Debt Crisis & The US Prime Rate above.

For more on how the US Prime Rate works, visit our homepage, this page, and this page featuring a Prime Rate flow chart.

For the latest Prime Rate forecast, stay tuned to this blog.

If you have a fixed-rate mortgage and you're worried that your interest rate may rise, don't. A fixed-rate mortgage won't be affected by either a ratings downgrade or the extremely unlikely situation where the US government defaults on its debt.

If you have a variable-rate mortgage and you're thinking that now may be a good time to lock in a favorable interest rate, you may want to consider refinancing your mortgage loan.

S&P Downgrade & Certificate of Deposit (CD) Rates

The S&P downgrade will have no significant effect on CD rates either. CD rates have been very low since 2008 because the Fed lowered short-term rates to record lows in an effort to boost economic growth. Bottom line: rates on CD's will start to climb when the Fed starts to raise short-term rates, and the Fed's next cycle of rate hikes is many, many months away (inflation is tame, economic growth is still anemic and unemployment is still high.)

If you're looking for a stronger return on your savings in the current interest-rate environment, you may want to consider using a reputable peer-to-peer loan network like Lending Club. Typical returns at Lending Club are currently north of 9%. With Lending Club, risk is minimized as all borrowers are vetted thoroughly; nascent and circumspect Lending Club investors can get their feet wet with micro loans.

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