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

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I'm in the market for a mortgage with a 30-year term and a fixed interest rate. How does the U.S. Prime Rate affect the rate I'm going to get on my mortgage?
I've read the definition of the Prime Rate on this website's homepage, but I'd like more information about how the U.S. Prime Rate works. Where can I find such information?
What's the difference between a home equity loan (HEL) and a home equity line of credit (HELOC)?
Is the Prime Rate the main benchmark interest rate for the United States?
How accurate are the Prime Rate predictions based on the fed funds futures market?
I want regular updates regarding the U.S. Prime Rate. How can I get free updates from this website?
I understand that if the Prime Rate is going to change, it's going to happen after a Federal Open Market Committee (FOMC) meeting. So, how often does the FOMC meet? Is there a fixed schedule of FOMC meetings?
What is the Federal Reserve's discount rate and does it have anything to do with the Prime Rate?
For a student loan offer I'm considering, I have a choice of having the loan indexed to the U.S. Prime Rate or the 3-Month LIBOR rate. Which should I choose, and why would this American bank use a European index?
I understand that the formula for determining the U.S. Prime is Prime Rate = (Fed Funds Target Rate + 3), but since the fed funds rate is the bank's cost of funds, why don't banks simply use the fed funds rate as the index for pricing loans?
Why is it that the rate on a 12 month certificate of deposit (CD) moves up and down with the Fed Funds Target Rate?
How does the LIBOR work?
I understand that the Wall Street Journal® polls ten (10) of America's largest banks when fixing the U.S. Prime Rate. Where can I find a reliable list of the 10 largest banks in the United States?
My credit card's APR is indexed to the U.S. Prime Rate. Numerous rate cuts by the Federal Reserve have caused the Prime Rate to drop considerably, but the APR associated with my credit card hasn't been reduced by a corresponding amount. Why?
It's July 2009, and the Prime Rate is at 3.25%. Is 3.25 as low as the U.S. Prime Rate can go?
What is the TED spread, and why should I pay attention to it?
My question isn't answered in this FAQ. How can I contact the publisher of this website?

1. I'm in the market for a mortgage with a 30-year term and a fixed interest rate. How does the U.S. Prime Rate affect the rate I'm going to get on my mortgage?

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

2. I've read the definition of the Prime Rate on this website's homepage, but I'd like more information about how the U.S. Prime Rate works. Where can I find such information?

Click here to read more about how the U.S. Prime Rate works, and you can click here to jump to a Prime Rate flow chart.

3. What's the difference between a home equity loan (HEL) and a home equity line of credit (HELOC)?

Both home equity loans (HEL's) and a home equity lines of credit (HELOC's) are second mortgage loans which are secured by a home (secured meaning the home is collateral. If the borrower gets into trouble servicing the loan, the home could end up in foreclosure.)

A HEL is like a first mortgage in that the interest rate is fixed, the borrower receives a lump sum at closing and the borrower will service the loan via amortized payments, typically for 15 years.

A HELOC, on the other hand, is more like a credit card, in that the interest rate is variable (usually indexed to the Prime Rate) and the borrower can access as much or as little of a given credit line over the life of the HELOC. HELOC's also resemble credit cards in that borrowers are only required to pay the interest that's due at the end of each statement month. The repayment term can be as long as 30 years.

Flexibility
Though HELOC loans come with a variable interest rate, which often makes them less attractive than a HEL, they can be useful for homeowners who like to keep their options open. That's because with a HELOC, you can transfer debt in or back out of the credit line as you wish. You can't do that with a HEL.

4. Is the Prime Rate the main benchmark
interest rate for the United States?

No, it isn't. The main, benchmark interest rate in the United States is the Federal Reserve's target for the fed funds rate. The fed funds rate is basically a healthy bank's cost for borrowing overnight funds from other banks via the Federal Reserve System. The U.S. Prime Rate is invariably 300 basis points (3.00 percentage points) above the Fed Funds Target Rate.

5. How accurate are the Prime Rate predictions based on the fed funds futures market?

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.

The FOMC has regularly scheduled meetings to decide on interest rates about every six weeks. The FOMC may also convene an emergency meeting at any time, if the chairman of the Federal Reserve decides that an emergency meeting is expedient.

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.

6. I want regular updates regarding the U.S. Prime Rate. How can I get free updates from this website?

You can get regular updates about the U.S. Prime Rate by subscribing to this website's free feed. Here are some subscription options:

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My Yahoo!:

Use the FeedBurner link to add the Prime Rate news feed to your Google Homepage, or to subscribe via My AOL, Newsgator, Rojo, Bloglines, NetVibes or PageFlakes.

You can also use the FeedBurner link to embed with SpringWidgets.

7. I understand that if the Prime Rate is going to change, it's going to happen after a Federal Open Market Committee (FOMC) meeting. So, how often does the FOMC meet? Is there a fixed schedule of FOMC meetings?

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.

8. What is the Federal Reserve's discount rate and does it have anything to do with the Prime Rate?

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.

9. For a student loan offer I'm considering, I have a choice of having the loan indexed to the U.S. Prime Rate or the 3-Month LIBOR rate. Which should I choose, and why would this American bank use a European index?

In the long run, what matters is the interest rate you will pay once the margin or spread is added to the index. When pricing a loan, a lender will often start with an index; a spread is then added based primarily on risk, and the resultant figure is the interest rate that the borrower will pay. So, for example, if a bank is offering a loan product with two indexing options, like:

Prime Rate (index) MINUS 50 basis points (spread) = X%

- OR -

3-Month LIBOR (index) PLUS 300 basis points (spread) = Y%

Bottom line: compare the X% and Y% APR's, and don't forget to factor in other borrowing costs, like points, or an origination, application or repayment fee.

To convert basis points to percentage points, move the decimal point 2 places to the left (e.g. 50 basis points is the same as 0.50 percentage point.)

Some lenders try to convince borrowers that LIBOR indexing is better for the borrower because LIBOR is always lower than Prime. Just remember: it's not about the index, it's about the spread. If you do your own math, you will end up much more comfortable with the loan you end up choosing.

So, why do some American lenders prefer to use LIBOR as opposed to the U.S. Prime Rate -- or some other American index like a Treasury Bill yield -- for pricing their loans?

Banks like the LIBOR rates because when global credit market conditions deteriorate, the LIBOR rates are modified rapidly and accordingly (LIBOR rates are updated every UK business day.) Risk is a lender's primary concern, so it can be argued that pricing loans using an index that's more sensitive to the unpredictable nature of global money markets is more practical. For instance, when the subprime mortgage-inspired credit crunch hit global financial markets back in August of 2007, the shorter-term LIBOR rates went up because financial institutions that participate in the London wholesale money market weren't sure which banks had exposure to subprime debt. Contrast that with the Fed's response: in mid-September of 2007, the Federal Reserve responded to financial market turmoil and signs of economic weakness by initiating a cycle of lowering the fed funds target rate (FFTR) (and lowering the U.S. Prime Rate, by extension.)

Bankers around the globe look to LIBOR when they want to know the real cost of money in the global financial marketplace.

NB: The FFTR and the U.S. Prime Rate are controlled by America's central bank: the Federal Reserve. The LIBOR rates, on the other hand, are not controlled by England's central bank, or any other central bank for that matter.

Some good LIBOR resources:

To understand how LIBOR works, click here.
This chart which compares the 1- & 3-Month LIBOR rates with the U.S. Prime Rate and the FFTR.
This book review.

10. I understand that the formula for determining the U.S. Prime is Prime Rate = (Fed Funds Target Rate + 3), but since the fed funds rate is the bank's cost of funds, why don't banks simply use the fed funds rate as the index for pricing loans?

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.

11. Why is it that the rate on a 12 month certificate of deposit (CD) moves up and down with the Fed Funds Target Rate?

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.

12. How does the LIBOR work?

To understand how LIBOR works, click here.

13. I understand that the Wall Street Journal® polls ten (10) of America's largest banks when fixing the U.S. Prime Rate. Where can I find a reliable list of the 10 largest banks in the United States?

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.

14. My credit card's APR is indexed to the U.S. Prime Rate. Numerous rate cuts by the Federal Reserve have caused the Prime Rate to drop considerably, but the APR associated with my credit card hasn't been reduced by a corresponding amount. Why?

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.

15. It's July 2009, and the Prime Rate is at 3.25%. Is 3.25% as low as the U.S. Prime Rate can go?

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.

16. What is the TED spread, and why should I pay attention to it?

Want to know how healthy the global financial system is? Check the TED spread.

The TED spread is the difference between the yield on the 3-month U.S. Treasury bill (a safe, 3-month loan to the U.S. government) and the yield on the 3-month LIBOR (a riskier loan to a bank in the London wholesale money market.) It's an important indicator of how much trust exists between large, international banks, which also makes it a good gauge of how freely capital is flowing through the international banking system.

In general, when the TED spread is high, banks are worried that short-term loans made to other banks won't get repaid. When the TED spread is low, banks are confident that short-term loans made to other banks will be paid back.

It's important for consumers and businesses looking for loans to pay attention to the TED spread, because when the flow of capital between banks is stifled, banks in turn not only cut back on the number of loans they make, their loan products also become more expensive.

So, let say you are the owner of a large American bank that has a presence in most of the major industrialized nations of the world, including London, England. You are sitting on a pile of cash and you are interested in making some profit with that cash via a short-term loan. Specifically, you want to make a loan with a term of 3 months. You have options:

You could lend the money to the U.S. government and make a small profit. However, the benefit of lending to the federal government is that the loan would be extremely safe. In other words, the odds that the U.S. government would default on that three-month loan are extremely small. After all, the federal government has the ability and the authority to simply print more U.S. dollars if it needs to. So it's a trade off: the risk is small, but so is the profit. To make a 3-month loan to the U.S. government, you would invest in a 3-month Treasury bill. To check the yield, you would go here.
Alternatively, you could make a 3-month loan to another bank in the London wholesale money market. The loan would be riskier than investing in a U.S. Treasury security, as a commercial or retail bank does not have the ability to print U.S. dollars. Moreover, the 3-month loan you plan to make would not be secured by any collateral. So, again, it's a tradeoff: making a short-term loan in the London wholesale money market is riskier than buying a U.S. Treasury security, but your profit would be larger. To get an idea of how much profit you could make on a 3-month, unsecured loan in the London money market, you would simply check out the yield on the 3-month London Interbank Offered Rate (LIBOR).

So, let's say the yield on a 3-month Treasury is 0.20%, and the 3-month LIBOR yield is 0.90%. The TED spread is the difference between the two, or 0.70 percentage point (which is the same as 70 basis points.) A TED spread below 50 basis points is a good indication that the global banking system is healthy. Above 50 basis points suggests that banks aren't making short-term loans to each other with confidence.

What Drives the TED Spread Higher?

A lower yield on the 3-month Treasury bill, or a higher yield on the 3-month LIBOR rate, or both.

Increased demand will cause the yield on U.S. Treasuries to decline as institutional and individual investors across the globe move money from riskier investments like stocks and corporate bonds to the safety of U.S. government debt.

The yield on the 3-month LIBOR will move higher when banks that participate in the London wholesale money market think that other banks may have problems paying back their short-term loans. The greater the perceived risk, the higher the rate.

The Peak of The Credit Crisis

During the fall of 2008, subprime lending and ill-conceived derivative products brought the international banking system to its knees. The global liquidity crisis was at its peak. Venerable Wall Street banks like Lehman Brothers and Bear Stearns failed. Large banks like Citigroup, Washington Mutual and Wachovia were also in big trouble due to bad investments and low-quality loans. The problem was global, as institutional investors (like the small town of Narvik in Norway) all over the world had money invested in failed financial products dreamt up by Wall Street hotshots. As a result, the TED spread hit the roof. On October 10, 2008, the 3-month LIBOR yield was 4.81875%, while the yield on the 3-month Treasury bill was 0.21%, which made the TED spread 4.60875 percentage points, or 460.875 basis points.

By May 21, 2009, the TED spread had dropped to 0.48625 percentage point, or 48.625 basis points, thanks in no small part to substantial and coordinated rescue efforts made by central banks and other government agencies across the industrialized world.

17. My question isn't answered in this FAQ. How can I contact the publisher of this website?

You can contact us by clicking here to jump to this site's email page.

by Steve "AmCy" Brown, FedPrimeRate.com^SM

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