What is the Prime Rate and Who Sets It?

The prime rate is the most favorable interest rate charged by lenders to their best customers, and "best customers" are typically large corporations that banks believe to present a very low risk. The prime rate isn't selected by the Federal Reserve or the government. It is chosen by banks in major U.S. financial centers. Other banks use the prime rate to determine their own prime rates. The prime rate is influenced by the federal funds rate. This is the interest rate that one bank will charge another bank for an overnight loan. The federal funds rate is set four times a year by the Federal Open Markets Committee, led by the Federal Reserve Chairman.

What the Prime Rate Affects Directly

The prime rate affects the following:

• Interest offered on savings accounts, money market accounts, and certificates of deposit
• Credit card interest
• Interest charged on home equity loans
• Interest on auto loans
• Interest on small business loans

What the Prime Rate Affects Indirectly

The prime rate has less of an effect on mortgage interest rates. Mortgage rates are more subject to influences of the bond market as well as general competition among banks. That's because most mortgages are sold to the public / private entities Fannie Mae and Freddie Mac, whose products compete in the bond market. Like bonds, mortgages are long-term investments. If, for example, bond rates were to go up to 7%, mortgage lenders would raise mortgage rates to keep mortgage products competitive in the bond market.

How to Use the Prime Rate to your Advantage

As a consumer, you can use changes in the prime rate to get an idea about what you'll pay on your credit. The better your credit score, the lower the interest rates you'll be charged for credit cards and other loans affected by the prime rate. If you notice the prime rate is increasing, you should watch rates that banks offer on savings accounts, money market funds, and certificates of deposit. If rates rise enough, you could benefit from moving your money to an account that pays a higher interest rate. While a 1% increase in interest on savings may not seem significant, over the long term, it could earn you significantly more.

How the Prime Rate Affects the Economy

The prime rate affects what is known as "liquidity." The lower the prime rate, the higher the liquidity. Increased liquidity means loans are less expensive and easier to get. Generally, when the prime rate is low, businesses are more likely to expand. As more businesses expand, the economy as a whole expands. By contrast, when the prime rate is high, liquidity falls, and this causes the economy to slow. You might think that banks would always like higher rates because they can charge more interest. However, higher rates mean that fewer individuals and businesses apply for loans, slowing lending overall. When the economy shows signs of inflation, generally the Federal Reserve raises the federal funds rate, to reduce demand for loans and to slow inflation.

Sources:

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http://www.bankrate.com/finance/credit-cards/how-prime-interest-rate-may-affect-your-monthly-bills.aspx
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http://www.bankrate.com/rates/interest-rates/prime-rate.aspx
http://budgeting.thenest.com/prime-rate-vs-mortgage-rate-3744.html