What Is the Importance of a Prime Rate?

The prime rate determines interest charged on loans.

The prime rate is an indicator used by many financial institutions as a base rate for most short-term loan products, such as ARMs and variable-rate credit cards. The prime rate helps to determine the interest rate charged to consumers for these short-term loan products.

Lending

Most major banks use the same prime rate to determine their base lending rates. This ensures competition and that profitable loans are issued, since the base is the same for these institutions.

Economy

The federal open market committe (FOMC) can spur economic growth by establishing a prime rate that most banks adhere to. The FOMC can then encourage industries by adjusting the prime rate and helping to maintain the maximum possible employment.

Personal Gain

With the FOMC meeting eight times annually, individuals can watch the prime rate and make decisions regarding their own personal finances. If rates are going down, it might be wise to wait for a lower rate on various loans. If rates are likely to increase, securing a loan soon will help to avoid higher payments.

Inflation

Inflation can be more easily controlled by using a prime rate as a benchmark rate. Lowering rates and allowing banks to more freely loan money to individuals and businesses can help stem rising inflation.

Credit Cards

The interest rates associated with most credit cards are tied to the prime rate. Most credit card companies offer an interest rate that directly references the prime rate. For example, a credit card company may offer an interest rate of 3 percent plus the prime rate; so, if the prime rate is 4 percent, the interest rate on the credit card would be 7 percent.

References

• The Fed Prime Rate