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A Primer on the Prime Rate

By Matt Kelley
Portfolio Strategy Manager, ESL Federal Credit Union

In March 2022, the Federal Reserve Bank (the Fed) raised its benchmark federal-funds rate for the first time since 2018. With this rate change, we may have a little 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 rates rise or fall, you’ll know what it means, both for you and the economy.

What are the federal funds rate and the prime rate?

The target federal funds rate, which is set by the Fed, serves as the basis for the prime rate. The federal funds rate is the interest rate commercial banks charge each other for overnight lending. Generally, the prime rate is about 3 percent higher than the federal funds rate. That means that when the Fed raises interest rates, the prime rate also goes up.

The prime rate is the rate at which individual banks and credit unions lend to their 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. ESL uses 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. You can find the current prime rate on the Wall Street Journal website.

Why does the prime rate change?

The Fed sets interest rate targets to manage the economy. As of March 2022, with U.S. unemployment rates at their lowest levels since pre-pandemic and inflation the highest it has been since the early 80s, the Fed is raising rates in an effort to cool the economy and combat inflation. As the U.S. economy irons out supply chain issues, fallout from the Ukraine crisis and faces a tight labor supply, raw material costs, shipping costs and wage pressure are driving up the costs of goods and services (otherwise known as inflation).

What does it mean for the economy when the federal funds rate and the prime rate go up?

Because 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, 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.

What does this mean for me and my finances?

An increase in the prime rate may increase loan 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 loans will also increase.

Please visit the following pages to see how the prime rate affects ESL loan rates: