What is the Prime Rate and How Does It Impact Home Equity and Credit Card Rates?

When looking for a home equity line, an auto loan, or a credit card, you may often run into the Prime Rate. Often, it is used as the benchmark to set these other product rates. What is the Prime Rate exactly and how is it set?

The Prime Rate, also referred to as the US Prime Rate is determined by polling the top 10 largest banks in the US. When at least 7 of the10 banks change their prime lending rate, then a new rate is published in the WSJ. So, the Prime Rate is an index put together from individual bank prime lending rates. It is not a law or a goverment set rate like the Fed Funds Rate. Banks do not have to adhere to it although many do for the sake of simplicity and for allowing easy product and rate comparisons.

Often a home equity line will be quoted as Prime +1. That means you take the prime rate, and add 1% point on top of it.Today's Prime Rate is 3.25% so the rate would be 3.25% + 1% = 4.25%.

The Prime Rate follows the Fed Funds Rate tighly. A rule of thumb for calculating the Prime Rate is the following:

U.S. Prime Rate = (The Fed Funds Target Rate + 3)

Looking at some actual rates, we can see that home equity line rates are generally 0-2% points above prime. The top line rate in Texas is 4.75%, which is 1.50% points above prime. It varies by state. For example, the lowest home equity line rate in New York is 4.25%, or just 1% point above Prime.

You'll also see Prime used quite a bit in variable rate credit cards. If you look at the legal and rate language, it is almost always quoted as so many percenrage points above prime. What been interesting here is that even as Prime has fallen, the credit card companies have not reduced their rates. That means the have increased the spread between Prime and what their cards charge.

When the Fed begins to raise rates someday in the future, look for Prime to go up with it. It's one way the Fed Funds Rate has such an impact on the economy.