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What Is the Prime Rate and How Does It Affect You? | Credit Card News & Advice

Key Takeaways

  • The prime rate is an important factor in determining how much interest you pay on credit cards and loans.
  • The prime rate is the benchmark interest rate that lenders use to determine what to charge customers.
  • It is based on the interest rate the Federal Reserve sets for short-term loans between financial institutions.

The prime rate is set by financial institutions. This reference rate serves as the base rate for many kinds of lending products, such as credit cards and mortgages, and is especially relevant for products with an adjustable interest rate.

Financial institutions use the federal funds rate, set by the Federal Reserve, to determine what the prime rate will be. Generally, the prime rate – also known as The Wall Street Journal Prime Rate or U.S. Prime Rate – tends to be about 3 percentage points above the federal funds rate.

The chart below shows a history of the prime rate in 2022 and 2023 and compares it to the federal funds rate. The time period ranges from March 2022, when the Fed started raising the federal funds rate to combat inflation, to August 2023, after the Fed had stopped raising rates.

How Does the Prime Rate Relate to the Federal Funds Rate?

The prime rate and federal funds rate are related, but they’re more like cousins than siblings.

While the Fed does not directly set the prime rate, the banks that do base it partly on the target level of the federal funds rate – the rate banks charge each other for short-term loans, which is determined by the Fed.

Members of the Fed’s Federal Open Market Committee, or FOMC, meet every six weeks to establish the federal funds rate. In some cases, the committee decides to move the rate up or down. In other cases, the committee leaves the rate unchanged.

“When people say the Federal Reserve affects consumers by setting interest rates, they skip a step in the logic,” says Noah Yosif, chief economist at the American Staffing Association. “The Federal Reserve sets interest rates at which banks borrow between each other, and when borrowing costs are higher, (banks) transfer them onto consumers via a higher prime rate. So, when interest rates are lower, banks save on borrowing and consumers save on borrowing from banks.”

As of April 2024, the federal funds rate ranged from 5.25% to 5.50%. Meanwhile, the prime rate stood at 8.50%.

The FOMC typically raises the federal funds rate to tame inflation or lowers it to stimulate the economy.

Lenders may offer their top-tier, lowest-risk customers the prime rate on credit products, but aren’t required to offer that rate to all of their customers. And even if the Fed adjusts the federal funds rate, lenders aren’t required to follow suit by adjusting their prime rate.

A financial institution or lender might set customers’ interest rates at, above or even below the prime rate.

What Is Affected by the Prime Rate?

The prime rate affects interest rates for a number of financial products. They include:

When these products have variable interest rates, the rate you pay may go up or down when the prime rate changes.

How the Prime Rate Impacts You

The prime rate impacts interest rates for both consumer credit and business credit, says Misha Mikhaylov, a chartered financial analyst and CEO of Llama Loan. “The prime rate affects essentially all forms of lending.”

So, when the prime rate rises, it could mean you end up paying a higher interest rate and, therefore, more interest on a new credit card or another new lending product. On the other hand, when the prime rate falls, you might pay a lower interest rate for a new lending product and save money on interest charges.

If the variable interest rate you’re already paying rises, your minimum monthly payment might jump due to higher interest charges. This is particularly true for credit cards. Nonetheless, credit card issuer Capital One says that most changes in the prime rate “have a pretty small impact” on monthly interest charges.

Let’s say the prime rate climbs from 8.25% to 8.50% and your credit card APR also increases 0.25%. In this case, you’d be hit with an extra $2.50 for every $1,000 that you still owe on a credit card. If the prime rate heads in the opposite direction, your interest burden should decrease.

Sarah Goldberg
Sarah Goldberg

Sarah is a seasoned financial market expert with a decade of experience. She's known for her analytical skills, attention to detail, and ability to communicate complex financial concepts. She holds a Bachelor's degree in Finance, is a licensed financial advisor, and enjoys reading and traveling in her free time.

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