Current Prime Interest Rate

As of this writing, the current prime rate is 3.25% and has been at that level since December 16, 2008. That being said, to truly understand what goes into the rate will require a bit more analysis.

Contrary to popular belief, the prime rate is not set by the government, the Federal Reserve, or by market traders. Every financial institution is free to set their own prime rate at whatever level they choose. However, many financing contracts are tied to the “Wall Street Journal Prime Rate” which is the rate that is printed daily in that paper. To set the rate, the Wall Street Journal polls the top 10 banks in the United States to find the base rate for corporate financing that is the same between at least 7 of those banks.

Although the United States’ prime rate is not set by the Federal Reserve, it has historically moved in lockstep with the target for the Federal Funds Rate which is set by the Federal Open Market Committee eight times per year. In fact, the rule of thumb for computing the current prime rate is to simply add three hundred basis points to the Fed Funds Rate target. A 3.25% prime rate represents a 300 basis point spread over a Fed Funds target of 0 to 0.25%. The 300 basis point rule has not always held, though, as demonstrated by the prime rate’s low of 1.5% in 1934.

Current prime rates are not the rate that banks charge their best customers. Although this used to be the case, today they serve simply as benchmarks. Actual lending rates are set around the prime rate, with the vast majority of customers paying more and a very small pool of extremely creditworthy customers actually paying less.

The prime rate is important today because so many loans are tied to it. Most adjustable rate mortgages, or ARMs, fluctuate based on changes in the prime rate. In addition to this, most credit card and home equity debt is also tied to the prime rate. Although the prime rate has been extremely stable for 2009 and the beginning of 2010, as it changes, the cost of much consumer debt will also adjust. Because the prime rate is also the basis for business debt, any increase in the prime rate could also significantly hurt corporate earnings.

Although the prime rate may be one of the most misunderstood indicators in today’s economy it is nevertheless crucial. Not only does it greatly affect the cost of much of the debt in the American financial system, but its gyrations can significantly effect popular perceptions of the market.