The prime rate is an important determinant for credit card interest rates and bank lending rates. When the prime rate goes up or down, credit card and personal loan interest rates will follow suite.
People who get to borrow at the prime rate are considered the most creditworthy borrowers. As one's creditworthiness declines, as measured by a credit score, the higher the interest rate you must pay above the prime rate.
The Prime Rate
The prime rate reached a peak of 8.25% in the second half of 2006. As the economy weakened, the prime rate decreased all the way down to 3.25% at the start of 2009.
As of 2H2020, the prime rate was about 3.25% as of June 12, 2020 after the Federal Reserve slashed rates to 0% – 0.25%. For 2020, the Federal Reserve indicated it would be accommodating by not raising rates.
In 2022 the Fed started raising rates and by 2H2022, the prime rate was about 4.75 as of June 28, 2022. Further, the Fed indicated it will continue rapid interest-rate hikes to bring down high inflation. Even with all the market declines through 2H2022, I still think interest rates should stay low long term and that inflation is going to come back down and normalize.
How The Prime Rate Determined
Let's continue. The prime rate is determined by the Federal Reserve, the central bank of the United States. The Fed sets a fed funds target rate with the goal of maintaining a 2% target annual inflation while also shooting for full employment.
If inflation is running too high, the Federal Reserve will tend to raise the fed funds rate to slow down growth. If the Fed sees weakness on the horizon, the Fed will tend to lower the fed funds rate to spur borrowing and investments.
The Fed funds rate is the rate that banks lend to one another to keep up their reserve requirements. The fed funds rate is unfortunately unavailable to the U.S. consumer.
The Wall Street Journal surveys the largest U.S. banks for the rate most of them settled on and publishes this consensus rate as the prime rate. The prime rate typically ends up equaling the federal funds target rate + a 3% margin.
With the fed funds rate currently at 1.75% as of 2H2022, the prime rate is therefore about 4.75%. Below is a 10-year fed funds rate chart from 2012-2022. Notice how the Federal Reserve finally started cutting rates in 2019 after mistakenly hiking rates in 4Q2018. Then rates plummeted when the pandemic hit and stayed low until the Fed started raising rates in early 2022 and plans to continue through yearend.
The Prime Rate And Credit Cards
Credit card companies love to charge huge interest rates over the prime rate because they can. The U.S. consumer, with only a ~6% average savings rate, is highly undisciplined when it comes to their finances. Credit card companies know this, hence why they try and take full advantage.
If you need a loan, it's much better to get a personal loan instead of have revolving credit card debt due to the interest rate differential. You can get real personal loan rates here.
The average credit card interest rate was a whopping 17% as of 1H2020 and is still over 16% in 2022. It followed the fed funds rate up starting in 2015. Credit card companies have raised their average interest rate by 2% more than the fed funds rate has increased since 2015 in order to make even more money.
And notice below how the average credit card interest rate stayed relatively high even when the Fed Funds Rate was slashed in 2020 during the pandemic.
It is important to never have revolving credit card debt. Paying a 16% interest rate is a surefire way to stay poor for the rest of your life. Instead, pay off your credit card debt in full each month and start investing instead.
The prime rate also affects auto loan interest rates. Taking out a loan to buy a depreciating asset is another bad financial move. Unless the interest rate is 0% and you're spending at most 10% of your gross income on the cost of the car, you should probably save your money.
Prime Rate vs Mortgage Rates
Contrary to popular belief, the prime rate doesn't not affect mortgage rates as much as people think. Adjustable Rate Mortgages and 30-year fixed mortgages are more effected by LIBOR plus a margin and the 10-year government bond yield.
The 10-year bond yield can decline while the Fed raises rates or keeps them elevated. When this occurs, the yield curve flattens or inverts, which often signifies a significant slowdown in the economy.
An inverted yield curve is also a great opportunity to refinance your mortgage rate, as you get to borrow money for a longer duration more cheaply than at a shorter duration.
If you are a homeowner, I highly recommend tracking interest rates and taking advantage when rates come down to refinance your mortgage.
Check out the latest highly competitive mortgage rates online today. You can get free, real refinance quotes in one place from multiple qualified private lenders competing for your business. Thanks to technology, it's so easy to compare mortgage rates today. You can get multiple real quotes in under three minutes.
Prime Borrowers Get The Prime Rate
If you want to be eligible for the prime rate or pay as close to the prime rate as possible, you need to be a prime borrower.
A prime borrower is one who generally has over an 800 credit score and is not taking out a loan that puts a burden on their finances. Each lending institution has different requirements for how much one can borrow.
When the Federal Reserve starts cutting rates, the prime rate is likely to go down and vice versa. Lower prime rates doesn't mean you should go out and start buying things you don't need on credit.
You must still stay disciplined with your spending and investment habits if you plan to achieve financial freedom sooner, rather than later.
Recommendation To Build Wealth
Once you've refinanced your mortgage, it's a good idea to look at real estate investment opportunities.
The easiest way to invest in real estate is through Fundrise and CrowdStreet. These are the two premier real estate crowdfunding platforms for non-accredited and accredited investors. Both are free to sign up and explore.
Through real estate crowdfunding, you don't have to leverage up to buy property. You can focus your investments on qualified sponsors who are investing in commercial real estate projects around the country.
I personally believe the heartland of America is very attractive due to lower valuations, higher cap rates, and higher potential growth due to a demographic shift away from expensive coastal cities.
CrowdStreet is focused on these secondary cities. Meanwhile, Fundrise is a pioneer in geographical eREITs, which I find attractive. Achieving financial independence is all about saving money and making money. Real estate is by far my favorite asset class to build wealth. I've invested $810,000 in real estate crowdfunding so far in 18 commercial real estate projects around the country.