If you have a credit card, you may already know how interest rates could affect your personal finances. However, the factors that determine interest rates often stay hidden behind the scenes. One particularly powerful factor is called the prime rate. A bank, your credit card issuer, and other financial institutions use the prime rate as a baseline for determining interest rates for borrowers. Read on to learn how the prime rate works and the effect it may have on your financial life.
What Is the Prime Rate and How Can It Affect Your Credit Card?
Published June 19, 2024
3 min read
Key points about: prime rates
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A bank’s prime rate is the figure banks use as a baseline to set interest rates.
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The prime rate is based on the federal funds rate, which is the interest rate banks are charged to borrow money from each other overnight.
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As the prime rates change, so do interest rates for some credit cards or loans.
Prime rate definition
According to the Federal Reserve, the prime rate is a baseline number a financial institution uses to determine interest rates for its financial products. Lending institutions treat the prime interest rate more like a benchmark. They may determine each borrower’s interest rate by beginning with the prime rate and then adding a margin based on factors like individual creditworthiness.
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How the prime rate is determined
Technically, each lender determines its own prime rate. However, prime rates tend to be similar or identical. That’s because lenders usually base prime rates on one number set by the Federal Reserve called the federal funds rate, Experian explains. Banks often need to borrow money to maintain enough cash on hand for transactions. The federal funds rate is the interest rate the banks pay to borrow funds from other banks overnight.
The prime interest rate usually fluctuates along with the federal funds rate. Changes in the current prime rate could affect your car loan, mortgage rates, and credit card rates.
How the prime rate affects interest rates
The prime rate is the basis for interest rates across many financial products. However, the extent of the prime rate’s influence depends on the loan. When you apply for a loan or credit card, the current prime rate usually affects its interest rate. If a loan has a fixed interest rate, that means economic conditions don’t continue changing the interest rate after you’ve opened the account (though factors like missed payments may).
Most credit cards have a variable interest rate. That means interest rates continue to fluctuate with the prime rate. Card issuers usually change their prime rates as the Federal Reserve changes the federal funds rate. When the prime rate shifts, so do credit card interest rates.
Essentially, if inflation causes the federal funds rate to go up, your card issuer may pass that cost onto you in the form of a higher interest rate. Your credit card statement should show changes to your interest rate. Keep in mind that if you don’t carry a balance, these changes may not have much of an influence on your credit card bills.
Did you know?
Some credit card issuers, like Discover, may have cards with a low APR introductory offer. A low intro APR on your account means you'll pay less in interest charges during the introductory period on balance transfers and purchases as long as you keep your account in good standing.
Credit cards aren’t the only loans affected by changing prime rates. Adjustable-rate mortgages, small business loans, and some personal loans may also have variable rates.
The prime rate is one example of how economic trends and corporate finance may influence your budget. A prime rate change may also change the cost of carrying a credit card balance. Understanding the relationship between the prime rate and your credit card’s variable interest rate could help you make informed financial decisions.
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