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A Primer on the Prime Rate

By Jim Darcy, Treasurer, ESL Federal Credit Union
Updated January 4, 2019

The fourth Prime Rate increase for 2018 was approved on December 19, and it’s anticipated to increase two more times in 2019.

With the frequent rate changes by the Federal Reserve Bank (the Fed), we may have a little better understanding of the impact, but we still may be wondering “What does this mean for me?” and “What does this mean for the economy?”

Here are some straight-forward answers, so as the rates continue to rise, you’ll know what it means, both for yourself and the economy.

What is the Prime Rate?

The Prime Rate is the rate at which individual banks and credit unions lend to their most creditworthy customers, including large corporations. It is often used as a benchmark for other loans like credit card and small-business loans.

The Prime Rate is generally the lowest rate of interest in which money may be borrowed commercially. Here at ESL, we use the Prime Rate as a basis to calculate the Annual Percentage Rate (APR) on variable rate products including Home Equity Lines of Credit, Credit Cards, and variable rate Business Loans. ESL uses the Prime Rate as provided in the Eastern print edition of The Wall Street Journal.

How does ESL choose their Prime Rate?

As the Fed changes rates, the Prime Rate adjusts with it. We use a widely-accepted index, The Wall Street Journal, to determine our Prime Rate. The Wall Street Journal is the most common source for the Prime Rate index and publishes its rate based on what the top 30 banks in the U.S. list as their Prime Rate. According to The Wall Street Journal, on December 20 the Prime Rate increased to 5.50%.

Why Does the Prime Rate Change?

The Fed uses a target rate to manage the economy and combat inflation. Over the past eight years, the U.S. unemployment rate has decreased from 10.0% to 3.7%. As our economy reaches full employment, the wage pressure tends to drive up the costs of goods and services while decreasing the value of the U.S. Dollar (otherwise known as inflation). Recent economic information shows signs of inflation which brought about a 0.75% increase in the Federal Reserve Funds rate over the course of 2018. Each time these rate increases occur, the Prime Rate will continue to rise.

What does this mean for me and my finances?

An increase in the Prime Rate may increase product rates for businesses and consumers. At ESL, the Credit Cards, Home Equity Lines of Credit (HELOC), Business Line of Credit, and Variable Rate Business Term Loan rates are tied to the Prime Rate, which means as the Prime Rate increases the rates on these products will also increase.

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Please visit the following pages to see how the Prime Rate affects ESL product rates:

What does it mean for the economy when the Federal Funds Rate and the Prime Rate go up?

Since the Prime Rate is so closely tied to the Federal Funds Rate, changes in the Prime Rate are reflective of the Fed’s position on the economy. Increases in the Federal Funds Rate (and indirectly the Prime Rate) is seen as monetary “tightening” or “contractionary” policy. This action is consistent when the Fed is attempting to slow the economy and control inflation.

What does it mean for the economy when the Prime Rate goes down?

When the Fed lowers the Federal Funds Rate (and indirectly the Prime Rate) they are lowering the cost in which banks borrow funds from each other. This translates to the rates at which businesses and consumers borrow from banks and the interest rates that banks and other financial institutions pay on deposits. When the Fed lowers the Federal Funds Rate it is attempting to stimulate the economy. Lowering the Federal Funds Rate is referred to as monetary “easing” and tends to increase aggregate demand for goods and services as well as the employment rate. This can be viewed as inflationary as increased demand and employment lead to higher wage growth and higher prices for goods and services.

Why did the Prime Rate go up?

Congress has mandated the Fed to facilitate maximum employment while controlling pricing inflation and moderating long-term interest rates. As we enter into 2019, the Fed sees the U.S. economy as continuing to remain strong. Job creation has been consistent and moving toward the Fed’s full employment target and inflation is starting to increase with wage growth trending higher.