While it may be surprising to some, the prime rate isn’t determined by the Fed. Instead, the prime rate is actually determined by individual banks. However, it’s important to note that the prime rate is influenced by the federal funds rate. The federal funds rate is set by the Federal Open Market Committee which consists of twelve Fed members.
The federal funds rate is the rate that banks charge each other for short-term loans. This rate is used as a starting point to determine the prime rate for consumers. Generally, the prime rate is around 3% higher than the federal funds rate (currently 3.25%).
The Fed meets several times a year to discuss the economy’s current conditions. Here they determine if they need to make adjustments to the federal funds rate. For example, in 2021 the Fed announced two emergency rate cuts to ease the negative impact of the coronavirus pandemic. As a result of these cuts, the federal funds rate decreased. This directly impacted the prime rate determined which then also decreased.
The interest rate that you receive on most financial products is dependent on the prime rate. Although it generally isn’t the exact same amount. Customarily, the interest rates you receive will be above the prime rate. But, the amount will vary depending on the lender. For example, the average credit card APR on accounts assessed interest is currently 15.78%, more than 12% higher than the prime rate.
Most credit cards set variable ranges for interest rates depending on your credit score. For instance, if your credit card lender has a preset scale of 11% to 22%, those with excellent credit could expect rates around 11% while those with good credit may receive rates closer to 22%.
There is a direct relationship between the prime rate determined and your credit card APR. Similar to the relationship between the federal funds rate and prime rate, if the prime rate decreases, your credit card APR will also decrease. However, the amount of change will depend on how much the prime rate changes. This concept doesn’t apply to fixed rate financial products such as many personal loans and auto loans since you commit to a single rate when you open the loan.
The prime rate determined influences the rates that lenders set for you. However, you can still dictate the rate you receive by bettering your credit score. The better your credit score, the lower interest rates you’ll receive on existing accounts with variable rates.