I'm in the market for a mortgage with a 30-year term and a fixed interest
rate. How does the U.S. Prime Rate affect the rate I'm going to get
on my mortgage?
The U.S. Prime Rate has nothing to do
with the rate you will get on a 15- or 30-year, fixed interest rate
Mortgages rates are determined by the buying and selling of mortgage
securities by banks, investors and brokerage firms on Wall Street.
The notion that the U.S. Prime Rate influences long-term mortgage
rates is a common misconception.
When investors feel that the long-term outlook
for inflation is favorable, long-term mortgage rates tend to go
down. Conversely, when investors believe that the long-term inflation
outlook is unfavorable, then long-term mortgages rates tend to go
The U.S. Prime Rate is used by American financial institutions as
an index for:
What's the difference between a home equity loan (HEL) and a home
equity line of credit (HELOC)?
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.
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.
Is the Prime Rate the main benchmark
interest rate for the United States?
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.
How accurate are the Prime Rate predictions based on the fed funds
Prime Rate predictions based on the fed funds
futures market are most accurate within 45 days of the next scheduled
Federal Open Market Committee (FOMC)
monetary policy meeting. In other words, as the next FOMC meeting
approaches, forecasts based on the fed funds futures market get
more and more accurate with each passing day.
The FOMC has regularly scheduled meetings to decide
on interest rates about every six weeks. The FOMC may also convene
an emergency meeting at any time, if the chairman of the Federal Reserve
decides that an emergency meeting is expedient.
If you want to know whether the U.S. Prime Rate
is going to go up, down or stay where it is, then stay tuned to
blog for the latest Prime
You may be wondering how other websites can
predict where the Prime Rate will go 2, 5, or 10 years from now.
The answer is: they can't. Why? Because there are too many economic
variables that influence Federal Reserve decisions on short-term
interest rates. How can anyone know where the unemployment rate
or the Consumer Price Index (CPI) will be 5 or 10 years from now?
No one can. Bottom line: making interest-rate predictions that far
ahead in the future would be like offering a weather forecast for
a date 5 years into the future. Unless one has a time machine, it
simply can't be done.
I understand that if the Prime Rate is going to change, it's going
to happen after a Federal Open Market Committee (FOMC) meeting. So,
how often does the FOMC meet? Is there a fixed schedule of FOMC meetings?
The Federal Reserve's Federal Open Market Committee
convenes a monetary policy meeting eight times per year (about every
six weeks.) The FOMC may also hold an emergency monetary policy
meeting at any time, if economic conditions warrant.
The current FOMC monetary policy meeting schedule
can be found at www.FOMC.tv.
What is the Federal Reserve's discount rate and does it have anything
to do with the Prime Rate?
When a U.S. bank needs to borrow funds on a
short-term basis, it usually does so via the fed
funds market, borrowing from another bank at a rate controlled
by the Federal Reserve called the fed funds rate.
However, if a bank seeking funds can't find
a lender via the fed funds market, it can borrow directly from the
Fed, via the Federal Reserve's discount window facility. When a
bank borrows directly from the Fed, the rate it pays for the funds
is known as the discount rate.
The discount rate is actually an umbrella term
for 3 separate discount window programs: the primary credit rate
(for healthy banks), the secondary credit rate (for not-so-healthy
banks) and the seasonal credit rate (for smaller banks with seasonal
borrowing needs).The primary credit rate,
which is often called the primary rate, has nothing to do
with the U.S. Prime Rate, but consumers sometimes confuse the two.
For a student loan offer I'm considering, I have a choice of having
the loan indexed to the U.S. Prime Rate or the 3-Month LIBOR rate.
Which should I choose, and why would this American bank use a European
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)
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
funds target rate (FFTR) (and lowering the U.S.
Prime Rate, by extension.) See this
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.
I understand that the formula for determining the U.S. Prime is Prime
Rate = (Fed Funds Target Rate + 3), but since the fed funds
rate is the bank's cost of funds, why don't banks simply use the fed
funds rate as the index for pricing loans?
The 3 percentage points that's tacked onto
the fed funds rate exists to cover banks' cost of making loans,
costs like performing credit checks, paying loan officers to talk
with customers and process the loans, paying for legal paperwork,
etc. The Prime Rate is essentially the break even rate of interest
for banks making loans. To make money, banks will add a margin based
primarily on the risk of the loan; the higher the risk, the greater
Why is it that the rate on a 12 month certificate of deposit (CD)
moves up and down with the Fed Funds Target Rate?
Banks are always looking for the cheapest source of
funds. When you open a 12 month CD account at your local bank or
credit union, you are in essence lending your money to the financial
institution for 12 months. If your bank can borrow via the fed
funds market, and pay 3.5%, then why would they pay you 7% or
8% on a CD?
NB: The fed funds money market is not just for overnight
loans. Longer maturities can be negotiated between banks. Also,
banks can borrow on an overnight basis repeatedly, day after day,
as long as there are other banks willing to lend.
I understand that the Wall Street Journal® polls ten (10) of America's
largest banks when determining the U.S. Prime Rate. Where can I find
a reliable list of the 10 largest banks in the United States?
The 10 largest banks in the United States, ranked
by total assets, can be found here.
My credit card's APR is indexed to the U.S. Prime Rate. Numerous rate
cuts by the Federal Reserve have caused the Prime Rate to drop considerably,
but the APR associated with my credit card hasn't been reduced by
a corresponding amount. Why?
Certain banks use rate floors to shield themselves
in case the Prime Rate drops to a level these banks feel would render
many of their loan and credit products unprofitable. Here is an example
from the terms and conditions of an Advanta business credit card:
"...Your Variable Account Rate Index for any billing
cycle will be chosen by us from among the Prime Rates published
in The Wall Street Journal's "Money Rates" section during
the three (3) months prior to the month which contains that cycle's
Billing Cycle Closing Date, but will not be less than 5.00%..."
With this particular business credit card, any U.S. Prime Rate below
5.00% would be meaningless.
Is 3.25% the lowest the U.S. Prime Rate can go?
Yes, 3.25% is essentially the lowest the U.S.
Prime Rate can go. The odds that Prime will ever go lower are extremely
On December 16, 2008, the Federal Open Market
of the Federal Reserve set a target range of 0% - 0.25% for the
benchmark fed funds rate, which was the Fed's way of setting a "zero"
rate. American banks responded by setting their Prime to 3.25%,
in accordance with the Prime
Rate rule of thumb: Prime = (fed
funds target rate + 3).
Since it's unlikely that the Fed will reduce short-term rates lower
than zero, 3.25% is essentially the lowest that Prime can go (NB:
The European Central Bank, Denmark, Sweden and Japan have all experimented
American banks have followed the Prime Rate
rule of thumb since the second quarter of 1994, and, currently,
there exists no indication that the relationship between the target
fed funds rate and the U.S. Prime Rate is going to change.
What is the TED spread, and why should I pay attention to it?
Want to know how healthy the global financial system is? Check
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.
So, let say you are the owner of a large American bank that has
a presence in most of the major industrialized nations of the world,
including London, England. You are sitting on a pile of cash and
you are interested in making some profit with that cash via a short-term
loan. Specifically, you want to make a loan with a term of 3 months.
You have options:
You could lend the money to the U.S. government
and make a small profit. However, the benefit of lending to the
federal government is that the loan would be extremely safe. In
other words, the odds that the U.S. government would default on
that three-month loan are extremely small. After all, the
federal government has the ability and the authority to simply
print more U.S. dollars if it needs to. So it's a trade off: the
risk is small, but so is the profit. To make a 3-month loan to
the U.S. government, you would invest in a 3-month Treasury bill.
To check the yield, you would go here.
Alternatively, you could make a 3-month loan to another bank
in the London wholesale money market. The loan would be riskier
than investing in a U.S. Treasury security, as a commercial or
retail bank does not have the ability to print U.S. dollars. Moreover,
the 3-month loan you plan to make would not be secured by any
collateral. So, again, it's a tradeoff: making a short-term loan
in the London wholesale money market is riskier than buying a
U.S. Treasury security, but your profit would be larger. To get
an idea of how much profit you could make on a 3-month, unsecured
loan in the London money market, you would simply check out the
yield on the 3-month
London Interbank Offered Rate (LIBOR).
So, let's say the yield on a 3-month Treasury is 0.20%, and the
3-month LIBOR yield is 0.90%. The TED spread is the difference between
the two, or 0.70 percentage point (which is the same as 70 basis
points.) A TED spread below 50 basis points is a good indication
that the global banking system is healthy. Above 50 basis points
suggests that banks aren't making short-term loans to each other
What Drives the TED Spread Higher?
A lower yield on the 3-month Treasury bill, or a higher yield
on the 3-month LIBOR rate, or both.
Increased demand will cause the yield on U.S. Treasuries to decline
as institutional and individual investors across the globe move
money from riskier investments like stocks and corporate bonds to
the safety of U.S. government debt.
The yield on the 3-month LIBOR will move higher when banks that
participate in the London wholesale money market think that other
banks may have problems paying back their short-term loans. The
greater the perceived risk, the higher the rate.
The Peak of The Credit Crisis
During the fall of 2008, subprime lending and ill-conceived derivative
products brought the international banking system to its knees.
The global liquidity crisis was at its peak. Venerable Wall Street
banks like Lehman Brothers and Bear Stearns failed. Large banks
like Citigroup, Washington Mutual and Wachovia were also in big
trouble due to bad investments and low-quality loans. The problem
was global, as institutional investors (like the small town of Narvik
in Norway) all over the world had money invested in failed financial
products dreamt up by Wall Street hotshots. As a result, the TED
spread hit the roof. On October
10, 2008, the 3-month LIBOR yield was 4.81875%, while the yield
on the 3-month Treasury bill was 0.21%, which made the TED spread
4.60875 percentage points, or 460.875 basis points.
21, 2009, the TED spread had dropped to 0.48625 percentage point,
or 48.625 basis points, thanks in no small part to substantial and
coordinated rescue efforts made by central banks and other government
agencies across the industrialized world.
If the United States government fails to raise the national debt ceiling,
causing the US to default on its debt, how would this outcome affect
the US Prime Rate?
Sovereign Debt Crisis & The US Prime Rate
If the United States government opts to default
on the national debt, severe financial-market disruptions are likely
to occur. The United States Prime Rate, however, would not be affected.
The US Prime Rate, which is currently at 3.25%,
is as low as it can possibly go(1).
Therefore, it can't go any lower.
A default won't cause Prime to go any higher
either. That's because the Federal
Reserve isn't going to do anything to make any financial crisis
-- including a Treasury Department default on its various bills,
notes and bonds -- any worse than it has to be. It's 2011, and the
Fed is still trying to counteract the effects of the 2008 financial
crisis and subsequent Great Recession (high unemployment.) Raising
short-term rates, including the US Prime Rate, in the current economic
environment, would risk driving the economy back into recession.
However, the Fed does NOT have any direct control
over mortgage rates. And since 30-year, fixed-rate mortgages track
very closely with long-term Treasury yields, a government default
would almost certainly cause mortgages rates to rise. Why? Because
demand for government securities would decline rapidly as a result
of the federal government's downgraded credit rating. With Treasury
securities, yields rise as demand falls, and vice versa.
If the government defaults, it's likely that
interest rates associated with car and student loans would also
It's important to note that while Prime won't
be affected by a government default, credit-card rates can still
rise. Credit-card banks can't change the US Prime Rate, but they
can modify the margin they add to Prime with their variable-rate
cards are indexed to Prime. If you look at a card's terms and
conditions, you'll likely see the annual percentage rate (APR) defined
as Prime + Margin. Example:
"...Your APR will be the WSJ Prime Rate + 9.99%..."
So a bank may respond to a government default
by raising the margin -- the 9.99% -- to a higher figure.
If you're worried about the rates associated
with the credit cards you already have open, here's the skinny:
If your credit-card banks decides to raise your APR by raising the
margin, you'll be able to reject the increase and close your account.
If you close your account, you'll continue to make payments on the
account until it's paid in full, and you'll be able to do so at
the original rate you signed up for.
NB: Pay close attention to the mailings from
your credit-card banks. You don't want to miss any notices about
rate increases. If you do, and 45-days pass, you may end up with
a "surprise" rate increase.
It's Friday, August 5, 2011. Standard & Poor's has just downgraded
America's credit score from AAA to AA+. How will this affect the US
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
fed funds rate + 3).
The Fed also determines the rate banks pay when
they borrow money directly from the Federal Reserve (the discount
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.
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
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.
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