Prime Rate: Frequently Asked Questions (FAQ)

Click here to read more about how the U.S. Prime Rate works, and you can click here to jump to a Prime Rate flow chart.

Both home equity loans (HEL's) and a home equity lines of credit (HELOC's) are second mortgage loans which are secured by a home (secured meaning the home is collateral. If the borrower gets into trouble servicing the loan, the home could end up in foreclosure.)

A HEL is like a first mortgage in that the interest rate is fixed, the borrower receives a lump sum at closing and the borrower will service the loan via amortized payments, typically for 15 years.

A HELOC, on the other hand, is more like a credit card, in that the interest rate is variable (usually indexed to the Prime Rate) and the borrower can access as much or as little of a given credit line over the life of the HELOC. HELOC's also resemble credit cards in that borrowers are only required to pay the interest that's due at the end of each statement month. The repayment term can be as long as 30 years.

Flexibility
Though HELOC loans come with a variable interest rate, which often makes them less attractive than a HEL, they can be useful for homeowners who like to keep their options open. That's because with a HELOC, you can transfer debt in or back out of the credit line as you wish. You can't do that with a HEL.

No, it isn't. The main, benchmark interest rate in the United States is the Federal Reserve's target for the fed funds rate. The fed funds rate is basically a healthy bank's cost for borrowing overnight funds from other banks via the Federal Reserve System. The U.S. Prime Rate is invariably 300 basis points (3.00 percentage points) above the Fed Funds Target Rate.

In the long run, what matters is the interest rate you will pay once the margin or spread is added to the index. When pricing a loan, a lender will often start with an index; a spread is then added based primarily on risk, and the resultant figure is the interest rate that the borrower will pay. So, for example, if a bank is offering a loan product with two indexing options, like:

Prime Rate (index) MINUS 50 basis points (spread) = X%

- OR -

3-Month LIBOR (index) PLUS 300 basis points (spread) = Y%

Bottom line: compare the X% and Y% APR's, and don't forget to factor in other borrowing costs, like points, or an origination, application or repayment fee.

To convert basis points to percentage points, move the decimal point 2 places to the left (e.g. 50 basis points is the same as 0.50 percentage point.)

Some lenders try to convince borrowers that LIBOR indexing is better for the borrower because LIBOR is always lower than Prime. Just remember: it's not about the index, it's about the spread. If you do your own math, you will end up much more comfortable with the loan you end up choosing.

So, why do some American lenders prefer to use LIBOR as opposed to the U.S. Prime Rate -- or some other American index like a Treasury Bill yield -- for pricing their loans?

Banks like the LIBOR rates because when global credit market conditions deteriorate, the LIBOR rates are modified rapidly and accordingly (LIBOR rates are updated every UK business day.) Risk is a lender's primary concern, so it can be argued that pricing loans using an index that's more sensitive to the unpredictable nature of global money markets is more practical. For instance, when the subprime mortgage-inspired credit crunch hit global financial markets back in August of 2007, the shorter-term LIBOR rates went up because financial institutions that participate in the London wholesale money market weren't sure which banks had exposure to subprime debt. Contrast that with the Fed's response: in mid-September of 2007, the Federal Reserve responded to financial market turmoil and signs of economic weakness by initiating a cycle of lowering the fed funds target rate (FFTR) (and lowering the U.S. Prime Rate, by extension.) See this chart.

Bankers around the globe look to LIBOR when they want to know the real cost of money in the global financial marketplace.

NB: The FFTR and the U.S. Prime Rate are controlled by America's central bank: the Federal Reserve. The LIBOR rates, on the other hand, are not controlled by England's central bank, or any other central bank for that matter.

Some good LIBOR resources:

• To understand how LIBOR works, click here.
  
  
• This chart which compares the 1- & 3-Month LIBOR rates with the U.S. Prime Rate and the FFTR.
  
  
• This book review.

Want to know how healthy the global financial system is? Check the TED spread.

The TED spread is the difference between the yield on the 3-month U.S. Treasury bill (a safe, 3-month loan to the U.S. government) and the yield on the 3-month LIBOR (a riskier loan to a bank in the London wholesale money market.) It's an important indicator of how much trust exists between large, international banks, which also makes it a good gauge of how freely capital is flowing through the international banking system.

In general, when the TED spread is high, banks are worried that short-term loans made to other banks won't get repaid. When the TED spread is low, banks are confident that short-term loans made to other banks will be paid back.

It's important for consumers and businesses looking for loans to pay attention to the TED spread, because when the flow of capital between banks is stifled, banks in turn not only cut back on the number of loans they make, their loan products also become more expensive.

S&P Downgrade & The US Prime Rate

Friday, August 5, 2011: The credit rating for the United States (long-term debt) has been downgraded from AAA to AA+ by the ratings agency Standard & Poor's. This action by S&P may cause borrowing costs to rise for the federal government, and will likely produce some heartburn in a variety of domestic and international money markets. But it won't have any effect on the United States Prime Rate.

American banks are required to keep a certain amount of cash on reserve at the Fed. When necessary, banks can borrow cash from other banks on a short-term basis via the fed funds market. The Fed controls the rate banks pay for these loans via the fed funds target rate. The target fed funds rate, in turn, determines the US Prime Rate: Prime = (target fed funds rate + 3).

The Fed also determines the rate banks pay when they borrow money directly from the Federal Reserve (the discount rate.)

Government Borrowing via Treasurys vs. Banks Borrowing via The Fed

When the United States government needs to borrow money, the Treasury Department handles this by issuing Treasury bills, notes and bonds. Ratings agencies (Standard & Poor's, Fitch and Moody's) rate securities issued by governments all over the world, including those issued by the US Treasury Department. These agencies, however, do not rate any kind of borrowing done by banks via the Federal Reserve.

Banks borrowing via the Fed is a completely different animal than the government borrowing via Treasurys.

That's why the US Prime Rate won't be affected by a ratings downgrade by any agency: borrowing by banks to cover reserve requirements has nothing to do with the government borrowing via the Treasury Department.

Any financial-market turmoil caused by America's downgraded credit score may prompt banks to raise their lending rates, but Prime, currently at 3.25%, isn't going to rise or fall as a result. For more on this, please see the section on Sovereign Debt Crisis & The US Prime Rate above.

For more on how the US Prime Rate works, visit our homepage, this page, and this page featuring a Prime Rate flow chart.

For the latest Prime Rate forecast, stay tuned to this blog.

If you have a fixed-rate mortgage and you're worried that your interest rate may rise, don't. A fixed-rate mortgage won't be affected by either a ratings downgrade or the extremely unlikely situation where the US government defaults on its debt.

If you have a variable-rate mortgage and you're thinking that now may be a good time to lock in a favorable interest rate, you may want to consider refinancing your mortgage loan.

S&P Downgrade & Certificate of Deposit (CD) Rates

The S&P downgrade will have no significant effect on CD rates either. CD rates have been very low since 2008 because the Fed lowered short-term rates to record lows in an effort to boost economic growth. Bottom line: rates on CD's will start to climb when the Fed starts to raise short-term rates.