The prime rate is the interest rate that banks offer to the most trustworthy customers. If you have a good, or excellent credit score, you’re more likely to receive the prime rate.
When you apply for a loan, your lender has to run a check on your financial history to decide if you are an acceptable candidate. If your credit report is at least good, or perhaps even stellar, the lender will consider you creditworthy and will most likely reward you with their best interest rate—the prime rate, but this is only available to customers with a very good credit history.
If your credit report has issues, your lender may not consider you a great candidate for a loan. These issues may be related to missed or late payments, bankruptcies, etc. A lender may still approve your loan request, but they will need to make sure they will not lose money if you fail to repay the debt when it is due.
On the other hand, candidates with a good credit score will have an overall lower loan cost than someone who has bad credit because you will be offered the prime rate.
Lenders earn money when you borrow a loan by charging interest. When you receive a loan after your application has been approved, you will receive the amount of money you applied for—the principal.
However, the amount of money you pay back will be larger than the original principal, more or less, depending on your interest rate. The interest is, simply put, the overall cost of you borrowing the money. The lender is charging for a service just like any other service provider.
If you ever lend money, or put money into a savings account, you too will be earning interest on that money. By doing so, you reverse the situation: You are the one who is giving money to someone, and you have the right to charge interest.
Some loans are paid back in monthly installments, so you will be paying back interest each month, and the rate will depend primarily on your credit score. Other factors, such as the repayment period, the total amount you have borrowed, the lender’s offer, and the market will also impact the interest rate. Each month, when you make a payment, a large portion of that money will be paying off the principal, while the rest of it serves as an interest payment.
Note that the monthly interest rate is not the same as the APR—the annual percentage rate. This rate represents the annual cost of a loan. You need to make sure you are familiar with both of these rates when you are signing a contract with a lender. The APR includes costs other than monthly interest, such as the origination fee, and it is usually a better indicator of how affordable a loan is.
Individuals are not the only clients that financial institutions lend money to. They also work with companies. In fact, corporations are more likely candidates for the prime rate than an individual.
Corporations usually have financial departments that take care of the company’s money, debts, investments, etc. They are less likely to slip into financial problems because there is a team of professionals in charge of money management. However, an individual borrower can get the loan at the prime rate if their credit is excellent.
To explain how the prime rate works and how it is determined, we must explain the federal funds rate, as the prime rate greatly depends on it.
Just like how you need to have a certain amount of money in your account in some situations, at the end of each business day, banks cannot go below a certain percentage of deposits in the accounts they have at the Federal Reserve Bank. Some banks may have an excess of money, so they can lend it to another bank that may be facing a deficit. Banks at a deficit are also allowed to borrow from the Federal Reserve.
When a bank lends money to another bank, they also need to charge interest for this loan. This interest rate is called the federal funds rate. Nevertheless, this rate does not completely determine the prime rate. Rather, it serves as an indicator for the banks to adjust their prime rate accordingly. When the federal funds rate rises or falls, it may reveal important information about the country’s economy, which affects the average prime rate.
The average prime rate is established at the national level, and it serves as a reference by which different banks will determine their prime rate. With an excellent credit score, your interest rate will probably be as close as possible to the prime rate.
If you are planning to apply for a loan, and you have checked your credit report, you may know in advance that your interest rate will be low. If you would like to learn what it might be even before you go to the bank, you can check the prime rate online. However, make sure you are looking at a trustworthy source, such as the Wall Street Journal.
The prime rate can change. If the prime rate increases, other interest rates will increase as well, such as the rates for personal loans, credit cards, and mortgages. This can be particularly important if you opt for a loan with a variable interest rate. If your interest rate is not fixed, it will depend on the market, and it can change dramatically over time, positively or negatively, which is why variable interest rates are potentially risky. If you’re interested in keeping an eye on the prime rate, it’s good to know that it changes every six weeks.
An increased prime rate may stop individuals from taking out a loan if their credit score is closer to fair than to excellent. However, the prime rate also has an important role in keeping the national spending and borrowing under control. If the prime rates were too low all the time, everyone would be able to qualify for a loan, and the consumer debt would expand. The best-case scenario is keeping the prime rate stable.
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