What is “Prime?”

You’ve heard it before – “…with rates starting below Prime”…“Interest rate will never fall below Prime.”…“Current interest rate equals Prime plus 2 percentage points.”

So what exactly is Prime?

The Prime Rate is a benchmark interest rate that financial institutions use to set variable interest rates for loans, lines of credit and credit cards. Though Prime is not directly set by the Federal Reserve, the federal funds rate helps determine Prime at any given time.

The most commonly-used formula is calculated by adding roughly 3% to the federal funds rate. This U.S. Prime Rate is published in The Wall Street Journal and used by banks and other financial institutions across the country.

Prime Rate = Federal Funds Rate + 3%

Since Prime Rate is an index and note a legally-mandated minimum, individual banks have the option to set their own prime rates. However, most closely align with the rate published in The Wall Street Journal.

How it Affects You

If you have a credit card, line of credit or loan with a variable rate such as an Adjustable Rate Mortgage (ARM), your interest rate is likely based on Prime. When the Prime Rate increases, the interest you are charged increases along with it. This may be calculated on a daily basis, such as the APR on a credit card, or it may come into play when it is time to adjust your interest rate on something like an ARM loan or home equity line of credit.

If you’re considering a variable-rate loan, line, or credit card, it is important to understand how interest is calculated and when it adjusts. It may be daily, monthly, annually or over the course of a few years. Understanding the basis for this adjustment will help you plan for the future and decide if a variable-rate loan is right for you.