When you apply for a loan from your bank, depending on the level of
reserves that they have they may need to borrow money from another bank or from the
Federal Reserve in order to loan you money.
Getting a Loan
If you are one of the top borrowers in the country, you may be offered a loan at
the Prime Rate. Prime Rate is always calculated depending on how much
money a bank is borrowing money for. Remember, banks are lending money in order to make
money (through interest rate payments) and therefore if they have to pay 3% to borrow
money your rate as a borrower is going to be higher than this to allow the bank to
turn a profit on the interest you're paying versus what they are paying.
Prime Rate Loans
Some loans (especially home equity and credit cards) are quoted as a percentage over
Prime Rate. Again, tie the Prime Rate (which is currently at 3.25%) to the Federal
Funds Rate (0% to 0.25%) and it's pretty simple to see that even at 3.25%
the banks are making at least 3% on every dollar they loan at Prime Rate. As a matter
of history, the prime rate is typically tied to the Federal Reserve Rate at 3% above
the Federal Funds Rate.
If the Federal Reserve lowers their rates on the funds that they are making available
to banks for borrowing and they're setting the rate for banks to lend money for each
other, chances are better that banks are going to be willing to loan more money. This
is a simple matter of liquidity - the easier it is for a bank to borrow money and the
lower the cost of them to borrow that money the more likely they are to be willing to
Prime Rate and Loans
If you have an adjustable rate mortgage (an ARM) then chances are that your rate is
tied in some way to the Prime Lending Rate. This means that it's helpful for you to
understand how the Federal Reserve Funds Rate impacts the Prime Rate. Other
loans that might be tied to prime rate include student loans, home equity lines of
credit, and credit cards. All of these types of debt are tied in some manner to prime
rate (typically quoted as Prime Plus loans).
What Happens When The Federal Funds Rate Increases
When the Federal Reserve increases the Federal Funds rate that means that you can
count on your adjustable debt payments increasing. This is because of the
historic link between Federal Funds Rates and Prime Rate. Even a one half point
increase can make a significant difference in your interest payments and
cause you to owe more money on a monthly basis.
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What Happens When The Federal Funds Rate Decreases
When the Federal Reserve decreases the Federal Funds rate your adjustable loan
(mortgage, credit card, student loans and home equity loans) payments will decrease
Here's what the difference would be on a $100,000 loan if it were tied to Prime
Rate and the rate on the loan decreased .075% (less than 1%).
$99,918 *RATE OF 7%*
$99,905 *RATE OF 6.25%*
It's easy to see how much of a difference this minor change can make over the life
of a loan even with a minor drop in the rate.
See also: Interest Rate Changes,
Fed Funds Rate