Prime Interest Rate and How It Affects You

Two Ways Hikes in the Prime Rate Cost You Money

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The prime interest rate is what U.S. banks charge their best customers. It's usually the best loan rate available to non-banks. It's also called the prime lending rate, the prime rate, or even just prime. It's currently 5.25 percent.

Banks base the prime rate on the federal funds rate. That's the rate banks charge each other for special overnight loans. They borrow fed funds from each other to fulfill the Fed's reserve requirement each night.

Banks raised the prime rate when the Federal Open Market Committee raised the current Federal Reserve interest rate to 2.25 percent. The prime rate is typically three points above the fed funds rate.  

Two Ways the Prime Rate Affects You

Banks base most interest rates on prime. That includes adjustable-rate loansinterest-only mortgages, and credit card rates. That means your monthly payment increases along with prime. Therefore, pay attention if you hear the Fed is raising the fed funds rate. It means your costs are about to increase.

Banks base these rates on the prime rate, but the rate is a little higher. That's to cover banks' bigger risk of default. They've got to cover their losses for the loans that never get repaid. The riskiest loans are credit cards. That's why those rates are so much higher than prime. 

The prime rate affects liquidity in the financial markets. A low rate increases liquidity by making loans less expensive and easier to get. When prime lending rates are low, businesses expand and so does the economy. Similarly, when rates are high, liquidity dries up, and the economy slows down.

Prime Rate Versus Libor

Not all banks base their other interest rate on the prime rate. International banks and large banks with a lot of foreign customers use the London Interbank Offer Rate. It's the rate banks charge each other for short-term loans. 

The fed funds rate, Libor, and the prime rate normally move in tandem. The prime rate is above Libor. The one-month Libor rate is a few tenths of a point above the fed funds rate.

When the rates don't move together, that indicates that something is wrong with the financial markets. For example, in September 2007, the Fed lowered its funds rate down half a point. Libor didn't budge. Banks were afraid of getting subprime mortgage debt as collateral from each other. They kept Libor high to offset this risk. Banks were so afraid to lend to each other that they kept raising Libor even as the prime rate fell.

When the Fed lowered its interest rate from 5.25 percent to 4.75 percent on September 18, 2007, the prime rate also dropped, from 8.25 percent to 7.75 percent. Libor rose from 5.5 percent to 5.6 percent. As the Fed continued to lower its rate, the prime also fell. Libor bounced up and down. That indicated the high level of irrational fear between banks. 

On October 8, 2008, when the Fed lowered its rate to 1.5 percent, the prime rate dropped to 4.5 percent. Unbelievably, it was barely above Libor, which stubbornly remained at 4.3 percent. That occurred weeks after the panicked run on money market funds that almost brought the U.S. economy to collapse. This Fed rate cut was part of a coordinated effort among all the world's central banks to shore up the collapsing financial markets. It was only a few days after Congress passed the $700 bank bailout bill.

Banks were in a state of sheer panic. The 2008 financial crisis timetable reveals how events led to the worst economic crisis to hit the United States since the Great Depression.

Soon afterwards, Libor slowly started returning to normal. When the Fed lowered its rate to zero in December 2008, the prime rate obediently fell to 3.25 percent. Libor dropped to 2.19 percent. It took another year before it returned to its typical range, a few tenths of a point above the Fed's rate. ​

A peek into the Libor rate history will show you how Libor compared to the fed funds rate each year and what happened when these two rates started diverging from their normal, mutual course. Having some knowledge of how these two rates affect each other could warn you of an impending financial crisis.