If you are shopping for a new credit card, an education loan, a car
loan, a business loan, a personal loan or a specific type of second
mortgage called a home equity line of credit (HELOC) then you need
to understand how the U.S. Prime Rate works.
The US Prime Rate is a popular index used by American banks for
the pricing of certain types of loans. Most American banks, credit
unions and other lending institutions use the U.S. Prime Rate as
an index or base rate for numerous loan products; a margin is added
to the Prime Rate depending on how risky the lending institution
feels the loan is: the riskier the loan, the higher the margin.
However, since the Prime Rate is an index and not a law, business
owners and consumers can sometimes find loan products that have
an interest rate that's below the U.S. Prime Rate, especially if
the loan in question is secured.
The U.S. Prime Rate is determined by adding 300 basis points (3.00
percentage points) to the federal
funds target rate (also known as the fed funds target rate.)
So if the fed funds target rate is 0.25%, then the U.S. Prime Rate
will be 3.25%.
The federal funds target rate is America's most important short-term
interest rate, and it is controlled by a group within the U.S. Federal
Reserve system called the Federal Open Market Committee (FOMC).
The FOMC convenes a monetary policy meeting eight times every year
to decide whether to raise, lower or make no changes to the fed
funds target rate. The FOMC may also hold an emergency meeting at
any time, if economic conditions warrant.
If the FOMC determines that the pace of inflation
within the U.S. economy is too high, then the group is more likely
to raise the fed funds target rate, so as to bring inflation under
control. Conversely, if the FOMC determines that:
- the unemployment
rate is too high, or
- The U.S.
economy is flagging in a significant way, or
- the U.S. economy
is in or is headed for a recession, or
within the U.S. economy is trending below the Fed's 2% target.
- a credit
crunch in the U.S. banking system is causing serious liquidity
issues within the U.S. economy,
then the group is more likely to lower the fed funds target rate,
so as to spur economic growth. If the U.S. economy is growing at
a moderate pace and inflation is also rising at a moderate rate,
then the FOMC is more likely to make no changes to the fed funds
When it comes to borrowing money, timing is very crucial, so it's
important for consumers and business owners to stay informed about
what the FOMC is likely to do with the fed funds target rate at
the FOMC's next
monetary policy meeting. If the U.S. economy
is showing clear signs of contraction, then holding off on a fixed-rate
loan may be a good idea, since in such an economic environment,
short-term interest rates, like the Prime Rate, may be on their
way down. On the other hand, if the U.S. economy is growing at a
very strong pace and the rate of inflation is relatively high, then
borrowing via a fixed-rate loan sooner rather than later may be
the smarter option, because in such an economic environment, short-term
interest rates may be on their way up.
Click here to view a Flow
Chart for the U.S. Prime Rate.