The prime rate is the best interest rate banks offer to their most creditworthy customers. Credit card companies typically add percentage points to this prime rate to set their rates.

If the prime rate goes up or down, your credit card Annual Percentage Rate (APR) will follow suit. When the prime rate goes up, borrowing money on your credit card becomes more expensive. Conversely, when the prime rate goes down, borrowing becomes cheaper.

History of the Prime Rate

The tracking of the prime rate began in the 1940s, essentially as the best rate banks would offer to their reliable, big business customers. Over time, the use of this rate expanded, affecting the amount consumers pay on loans, including credit cards and mortgages.

The prime rate fluctuates based on the overall performance of the economy. Its impact spreads across the economy, helping to control borrowing costs. Typically, rates rise when the economic situation is good and everyone is spending a lot, as more borrowers compete for loans.

How the Prime Rate is Determined

Banks set their prime rates by studying factors such as the Federal Funds Rate (the rate at which banks lend to each other), market performance, and signs of the economic condition. These factors help banks determine how much to charge their most creditworthy customers for loans.

How the Prime Rate Affects Financial Products

The prime rate affects the interest you pay on loans and credit cards. When the prime rate goes up, you generally need to pay more interest. When the prime rate goes down, the interest you pay decreases.

Credit Cards

Credit card companies typically tie the interest rates they charge (known as the Annual Percentage Rate, or APR) to the prime rate. They add a certain number of percentage points to the prime rate to come up with your APR. For example, if the prime rate is 3%, and they add 19 percentage points, your APR would be 22%. This means if you carry a balance on your credit card, you’ll pay more interest.

If the prime rate drops, the process works in the same way but in the opposite direction. Issuers might lower your APR and the interest you pay. However, the speed at which credit card rates are lowered is usually slower than the speed at which they are raised.

Loans and Mortgages

Like credit cards, the prime rate affects the rates for other types of loans and mortgages, but the rate for each loan and mortgage differs slightly.

For personal loans, especially unsecured loans (where you don’t need to provide collateral like your house or car), the rate you get is very sensitive to the prime rate. Banks start with the prime rate, then add a certain number of percentage points based on how risky they think lending money to you is.

If the base rate goes up, banks raise the rates, so new loans become more expensive. However, existing personal loans usually have a fixed rate, so your repayments should remain the same even if new loans become more expensive.

Fixed-rate mortgages have a rate that stays the same throughout the loan term, usually 15 or 30 years. Only at the time the lender issues the loan does the prime rate affect fixed-rate mortgages. After that, your rate doesn’t change, even if the prime rate goes up or down.

Auto Loans

Auto loans and leases are similar to credit cards and some home loans in that the interest you pay changes with the prime rate. But for auto loans, the prime rate isn’t the only factor affecting the rate. Your credit score and economic conditions also play a significant role.

When the prime rate is low, you can get more favorable auto loans. Your monthly repayments during the loan term would also be lower. Sometimes, you might even find auto loans that charge no interest for a certain period.

The prime rate is a key component of the financial landscape, affecting loan costs and reflecting economic performance. Understanding the prime rate can help you make better choices for your personal and business finances.

Keeping an eye on the base rate can let you decide when to borrow money or make significant financial decisions, which could save you a lot of money in the long run.