How Do Banks Change Rates Based on the Prime Rate?
Banks base the interest rates that they pay depositors and charge borrowers on the U.S. Prime Rate. Banks establish their own Prime Rates, but they always work in unison. The Wall Street Journal polls the 10 largest banks in the U.S. to determine changes in Prime Rate. When at least seven of the 10 change their rate in unison, the Wall Street Journal updates its published U.S. Prime Rate.
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History
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In 1933, Congress officially established the Federal Open Market Committee, composed of governors and chairmen of the 12 Federal Reserve regional banks. The FOMC determine the Federal Funds Rate, which prices inter-bank lending. In 1995 the FOMC began to publicly announce the Federal Funds Rate. The Wall Street Journal had previously relied upon a poll of the Prime Rate at the 30 largest banks in the U.S. to estimate the rate, knowing that Prime Rate was based on the Federal Rate. Since the rates became public, Prime Rate has always been 3 percent above the Federal Funds Rate.
Function
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The FOMC meets at least four times a year and change rates to stimulate lending or curtail spending. Banks in good financial standing borrow money from the Federal Reserve or each other and lend it to customers. Banks generate income by marking up money they borrow at the Federal Funds Rate to the U.S. Prime Rate. Traditionally, the most creditworthy consumers could borrow at Prime Rate, which capped banks profit margin to 3 percent.
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Effects
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Banks use long-term deposit money held in consumer certificates of deposit to make loans. Banks search for the cheapest money available, and when the Federal Funds Rate falls, CD rates fall. Banks do not want to pay a CD account holder a high rate of interest when they can acquire the money more cheaply from the Federal Reserve. When the Federal Funds money becomes expensive, banks raise rates to keep their profit margins on loans.
Misconceptions
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The Prime Rate does not affect all loan rates. Mortgage rates are not directly affected by changes in the Federal Funds Rate or the U.S. Prime Rate. Mortgage rates are based on average yields paid in the bond markets. Some banks do not even use the Prime Rate to price home equity loans and instead use the London InterBank Offered Rate, the English version of Prime Rate. Sometimes currency exchange rates enable banks to profit more from using LIBOR.
Warning
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Most credit cards and home equity lines of credit have variable rates attached to Prime Rate. There are no caps on Prime and most banks allow credit products to rise as high as 20 percent in conjunction with Prime Rate before reaching their own rate ceilings.
CD investors will not keep pace with inflation when banks borrowing costs are low. CDs offer FDIC principal protection but over time, inflation erodes the spending power of people who invest solely in CDs.
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