The prime rate determines the rates for mortgages, personal loans, and small business loans. The lenders mostly charge this rate to their most favored borrowers. This rate is used as the base for calculating rates for variable-rate mortgages.
In real estate, ‘rate’ plays an important role as the interest amount is determined by calculating the rate. Thus, it is important to understand the definition of the prime rate. As a real estate professional, my job is to explain the real estate definitions more simply. This way, it is easier for the students to prepare for their real estate exams.
In this post, I will explain the prime rate definition in an easy-to-understand way. After reading this post, you’ll be able to define prime rate and learn how it works.
What Is the Prime Rate?
The prime rate is the lowest interest rate the banks offer to their best customers. These customers are mostly those that have a high credit rating and have minimal risk of default. The prime rate is mostly 3% above the Federal Reserve’s federal funds rate.
If the Federal funds rate changes, the prime rate also changes. For instance, if the federal funds rate is 4%, the prime rate is +3 more, and it will be 7%. Usually, banks can set the prime rate for their customers, which is available to all those borrowers who qualify.
The prime rate is also known as the lending rate or prime interest rate. Banks use this rate on loans and products they offer to their borrowers. Only stable businesses, such as large corporations, qualify for the prime rate. The prime rate might not change for years or many times within a year, depending on the economic conditions.
How Is the Prime Rate Determined?
The prime rate is determined by the federal government, instead, every bank sets a prime rate for its creditworthy clients. But it is affected by the federal funds rate that the Federal Open Market Committee (FOMC) sets. The federal funds rate is the rate that the banks charge each other for providing short-term loans. The banks use the federal funds rate as a base for setting the prime rate for their favored customers.
To set the prime rate, banks usually add +3 to the federal funds rate. Thus, the prime rate is approximately 3% more than the federal funds rate. This is how banks determine the prime rate and charge their clients who have a good credit rating and financial stability.
How does Prime Rate Work?
The prime rate is a type of interest rate that banks offer their favored customers. Interest rate is the rate that lenders charge their borrowers for offering a mortgage. This is the rate that acts as compensation for the risk that the lenders take by providing a mortgage to the borrowers. The interest rates are noted annually and are known as the Annual Percentage Rate (APR).
Borrowers interested in variable-rate mortgages must understand how prime rates work. This helps the borrowers calculate the cost of the mortgage and monthly payments during the mortgage term. The Federal Reserve plays no direct role in determining the prime rate, but most banks set their prime rates according to the federal funds rate set by the Federal Open Market Committee (FOMC).
Usually, when the federal funds rate changes, one of the banks announces a change in their prime rate the same day. The change in rate doesn’t occur daily or weekly like other rates; it only changes when the federal funds rate moves. When a bank changes its prime rate according to the new federal funds rate, the rates for many of its loans and mortgages also change in the same direction.
When the federal funds rate goes down, the prime rate decreases, and the lending products become less expensive. Remember, the rate for the mortgage changes only when it’s an adjustable-rate mortgage; the rate remains fixed for fixed-rate mortgages.
Overnight Rate vs. Prime Rate
The overnight rate is the rate the banks usually use to borrow or lend from other banks or financial institutions. When a bank is short of its federal reserve requirements, it borrows from another bank with extra reserve. If the overnight rate is high, the rates for customers become high, too, as the banks pass on the increased price to their customers.
On the other hand, the prime rate is the rate the banks set on their own, but it is mostly in line with other banks. The prime rate affects the mortgage rates, but only the adjustable rate mortgages. With a fixed-rate mortgage, the rates are mostly associated with the government bond yields. Prime rate may not be available to individuals; mostly, large corporations qualify for it.
The Effect of Prime Rate On Lending Products
The prime rate affects the lending products in different ways. The changes in prime rates may affect the terms of loans and mortgages. The mortgage rates and terms can be lower or higher depending on the prime rate. Besides that, the mortgage type, credit score, and other factors also affect the rates. Changes in the prime rate can affect the following lending products:
Most banks and credit card companies offer variable interest rates for credit cards. For instance, they might charge a ‘prime plus 11.99%’. As the prime rate changes, credit card users will notice a relative change in their card’s APR within one or two billing cycles.
Car loans are affected by the prime rate, especially if the car sellers want to gain more profits. The car loan rate is usually lower for used cars than new cars. The prime rate also differs according to the credit score of the borrower.
As mentioned earlier, the prime rate affects only adjustable-rate mortgages. As the prime rate fluctuates, the rate for the adjustable rate mortgages also fluctuates. The impact of the prime rate is greatly felt on short-term mortgages. These mortgages have high rates because they are short-term. On the other hand, if the borrower has a long-term mortgage of 20 or 30 years, the monthly payment won’t increase or decrease much if the prime rate changes.
Prime Rate Examples
Tom has an adjustable-rate mortgage that will fluctuate according to the prime rate. The bank will charge an interest rate of 3% above the prime rate. When Tom took the mortgage, the federal funds rate was 3.75%. Tom’s prime rate for the mortgage is calculated as follows:
- Prime rate: Fed rate + 3% = 3.75% + 3% = 6.75%
Thus, Tom had to make monthly payments which included an interest amount of 6.75% along with the principal. However, the next year, the federal funds rate increased to 4%, and the prime rate also changed:
- Prime rate: Fed rate + 3% = 4% + 3% = 7%
Tom’s monthly payments have increased as the mortgage rate has increased to 7%. Similarly, if the fed rate decreases, the prime rate will also decrease, hence the monthly mortgage payments.
Frequently Asked Questions
What Is Meant by a Prime Rate?
The prime rate is the rate commercial banks charge their most favored customers. These customers are the most creditworthy and financially stable ones. All the banks set their own prime rate, but the federal funds rate usually determines it. Banks set the prime rate by adding +3 to the federal funds rate.
What Is the Difference Between Fed Rate and Prime Rate?
The federal funds rate is the rate that the banks charge other banks for lending loans overnight. The banks borrow and lend to each other to maintain the reserve requirements. The prime rate is usually 3% lower than the federal reserve rate. However, they are directly related; if the federal rate increases, the prime rate also increases, and vice versa.
What Is the Prime Rate Today?
The current prime rate is 7.5% in the U.S. as of December 15, 2022. The federal funds rate is 4.25% to 4.5%. So, if you want to know the prime rate, you just have to add +3 to it, and you’ll have it.
What to Know for the Real Estate Exam
Banks offer prime rates to their most favored customers with the highest credit ratings and financial stability. Each bank can set the prime rate; some banks can charge more or less depending on their financial goals. However, in most cases, the prime rate is 3% more than the federal funds rate. When the prime rate increases, the cost to access home equity loans, line of credit, car loans, small business loans, credit cards, and certain mortgages also increases.
Do you now understand how the prime rate works? If you have any confusion, let me know in the comments. Want to learn more about such real estate definitions? Visit this extensive collection of real estate terms.