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If you read the Disclosures that mail with your credit card statement — or if you read them online before you apply for a credit card — you’ll see that many credit card companies offer an interest rate of “Prime + X %.” But what does this mean? What is the Prime Rate?
The Prime Rate, otherwise known as the Wall Street Journal Prime Rate and published in the paper by that name, is a standard interest rate that banks use to set their interest rates on most short term loans and that consumers can use to compare interest rates on similar products.
The Prime Rate is sometimes called the “National,” “U.S.” or “Federal (Fed.)” Prime Rate. This rate does not change from state to state, but is a nationwide average.
How Is the Prime Rate Calculated? And Who Calculates the Prime Rate?
These are both very good questions. The WSJ calculates the Prime Rate by polling 10 of the United States’ largest banks. If seven of these 10 banks have changed their Prime Rate, the WSJ will calculate the average of all 10 and change the published Prime Rate.
Since mid-December 2008, the WSJ Prime Rate has been 3.25 %, which means customers with good credit can get very low rates on short-term personal loans, mortgages and credit cards. Any interest rate above Prime shows the credit card’s profit margin.
It’s important to note that the WSJ Prime Rate is an “index” or “standard” — not a law. You can find interest rates lower than prime or much higher.
Be cautious of any rates below prime (aka sub-prime.) These are sometimes offered — although not as frequently now as they were before the housing bubble burst — on mortgages and home equity loans as low introductory rates to entice customers into borrowing money they can’t afford to pay back at higher interest rates.
When these variable interest rates rise, customers discover they can no longer make payments and face foreclosure. You can read about how a foreclosure affects your credit score in this CreditShout article.
Many credit cards also offer introductory rates of 0 % for the first year. As long as you’re cautious not to charge more than you can afford to pay back within a year, these cards are great for transferring balances from higher interest credit cards.
Before we digress any further, lets discuss how banks set their interest rates, which results in an average Prime Rate.
The Prime Rate is tied to the “fed funds rate,” an interest rate set by the Federal Open Market Committee. When we hear a news report that the “fed” is changing interest rates, this is the number that will change. Banks may then change their interest rates accordingly.
Changes in the fed funds rate can stimulate or slow down lending or, alternatively, encourage customers to save money. The fed funds rate — and the resulting Prime Rate — affects interest rates on:
- Credit cards
- Home equity loans and lines-of-credit (HELOC)
- Personal and car loans
- Certificates of deposit
- Savings accounts
- Money market accounts
When the Fed wants to stimulate spending in order to increase the flow of money and help the economy by driving business, it may lower the interest rate. To control runaway inflation, however, the Fed must keep interest rates in check. It’s a delicate balancing act that is far too complicated to explain in a blog post.
In a nutshell, a team of seven people that make up the Federal Open Market Committee can influence the flow of money through the U.S. economy by setting the Fed Funds rate, which then determines the U.S. Prime Rate.
The decisions made by the FOMC affect the interest rates on your credit cards and any other loans or savings accounts you may have. So you may want to lock in a lower interest rate before the Fed raises rates again.