How the Prime Lending Rate Works

When you apply for a loan, you will see there are a wide variety of rates. Prime rates are the lowest rates you can pay. If you have several years in business and a high credit score, you will receive one of the lowest rates. The current prime rate is 3.25%.

Interest rates on other loans such as lines of credit or mortgages are based on the prime lending rate plus a premium which makes the interest rate higher. Read on to find out how a prime lending rate works and how it can affect your small business.

What Is the Prime Rate?

Depending on the state of the economy and lending market, the prime rate fluctuates and is given to the banks most creditworthy borrowers. You can qualify for a prime rate if you have a strong credit and strong personal financial history.

Banks and other lenders use the national prime rate as a starting point for loans, credit cards, business mortgages, and home mortgages. The U.S Prime Rate, also known as The Wall Street Journal prime rate, is a benchmark set used by financial institutions to determine how much interest to charge a bank’s customers on loans. It is typically about 3% higher than the federal funds rate.

How Is the Prime Rate Calculated?

The prime rate is calculated using the federal funds rate which is set by the Federal Open Market Committee (FOMC). When the federal funds rate goes up it leads to a prime rate increase. This means the rates for loans will be higher and the costs for consumers and business borrowers will be higher too.

Fixed-rate loans will not be affected but variable rate loans will and be impacted quickly. If you use a business credit card, you will see a rise in the rates too.

How to Qualify for The Prime Rate

One of the ways you can increase your chances of qualifying for a prime rate is having a good credit score. The higher your credit score is, the better chance you have at being approved for the loan. Your credit history is also taken into consideration because the longer you can show you have made payments on time, have little or no balance on your credit card, and only applying for the credit and loans you need, the better.

Also, it is important to keep in mind that having a decent debt-to-income ratio (DTI) is going to help your chances of approval. Lenders want to make sure that you will be able to handle the payments on the loan and see how much of your income is going towards payments of other debt obligations you have.

Impact of Prime Rate Changes

The following is a list of accounts that are directly affected by changes to the prime rate:

  • Mortgages: if you have a fixed rate it will not be affected but if you have an adjustable-rate mortgage (ARM) that is tied to the prime rate then you will see a change in your payments.
  • Home equity lines of credit (HELOC): if your HELOC has a variable rate, your payments will change.
  • Small business loans: your small business loan or credit line may be affected based on the prime rate fluctuation.
  • Small business credit cards: most business credit cards have variable interest rates that are tied to the prime rate.

The following is a list of accounts that are not affected by changes to the prime rate:

  • Credit cards: that are tied to APR based on LIBOR (London Interbank Offered Rate).
  • Student loans: changes will not be affected if they are tied to LIBOR.
  • Mortgages: fixed rate mortgages will not be affected.
  • Savings accounts: savings can change if they are directed to the prime.

Bottom Line

The prime rate is the lowest interest rate that you can get, but you must be well-qualified in order to get it. Understanding the prime rate will give you a better idea of how much a variable-rate loan will cost. Now that that you know how banks determine the prime rate you can see if it is something you can currently qualify for or not.