The prime rate is the lowest interest rate that commercial banks charge the best and most credit-qualified customers to borrow money. Prime rates, sometimes known as prime interest rates, affect almost every part of your financial well-being. If the prime rate is higher than average, it will cost you more to borrow money to purchase a house, for instance. If you’re a financial accountant, the prime rate and the prime rate forecast will be important in accounting regarding your assessment of your client’s financial well-being over the next several months.
The Prime Rate
The “prime rate” is also known as the “U.S. prime rate” or the “Wall Street Journal prime rate.” The world’s benchmark currency is the U.S. dollar, and the relative strength or weakness of the dollar has a direct bearing on any prime rate forecast that comes out of various U.S. financial entities. For finance purposes, the prime rate is normally set at 300 basis points, or 3 percent, above the interest rate set by the U.S. Federal Reserve Board. There is more to learn about this in courses such as Finance Bootcamp for Entrepreneurs.
The Federal Reserve itself is the U.S.’s central bank. The Fed, as it’s more commonly known, also has the power to print money. Plus, the Fed is considered the lender of last resort to banks in desperate need of bailing out, such as happened during the late-2008 financial crisis. Many financial entities struggled to come up with an accurate prime rate forecast during the late-2008 to mid-2009 economic period, by the way, as markets crashed and then rose yet again. The main job of the Fed, though, is really more about setting monetary policy to promote the nation’s economic health than it is about lending money.
The Fed’s monetary policy also affects the prime rate in various important ways, including when it sets the discount rate, or the interest rate it charges to lend money to commercial banks and other depository institutions. For example, if the Fed sets the discount rate at 1 percent, one could rely on a reasonable prime rate forecast being at about 4 percent. The Udemy course CFA Level 1 Economics provides excellent background on macro-economics and monetary and fiscal policy.
Setting the Prime Rate
Many different banks, financial institutions, lenders, financial services firms and various finance experts look at the cost to borrow money from the Fed on a daily basis. The Wall Street Journal calculates the prime interest rate on a daily basis to generate its extremely popular prime rate index. In fact, the WSJ’s prime rate index is considered the “unofficial official” source for the daily prime rate and the basis for a prime rate forecast.
Generally, the Wall Street Journal examines the daily base interest rate of loans made to corporations by 75 percent of the 30 largest U.S. banks. A mortgage lender, for instance, always looks at the WSJ’s prime rate index and then makes a series of calculations. Lenders generally consider what it would cost to borrow money from the Fed or the capital markets that they in turn would lend out to top-credit customers before setting their own interest rates.
Making a Prime Rate Forecast
Lenders and other financial institutions work very hard to make accurate prime rate forecasts because they need to plan out their own lending cycles. If a lender forecasts the prime rate incorrectly it may not be able to borrow sufficient capital to in turn fund its own lending activities. The prime interest rate can also be volatile, quickly rising and falling numerous times over a week or a month or year. On the other hand, prime rates sometimes stay steady for months at a time, allowing a financial analyst or lender or other financial entity to forecast prime rates very accurately.
Depending on the credit of the customer or client asking to borrow money, a lender may issue funds at exactly the prime rate. Most true prime rate loans only go to a bank’s very best and more creditworthy customers, however. Typically, a customer with good credit would see a loan from a bank at the “prime plus1,” or the prime interest rate plus an additional 1 percent. The lower a customer’s credit is the higher above the prime rate will be the actual interest rate charged to borrow a bank’s money.
Importance to the Markets
Many foreign capital markets and commercial banks also base their interest rates on the U.S. prime rate and the prime rate forecast made by their own financial analysts, but not always. The London Interbank Offered Rate, or LIBOR, is the average interest rate charged by banks in London. London is another major world financial center in addition to New York, Chicago, Tokyo and Hong Kong. Because the global financial system is so pervasive in this new millennium, the LIBOR and other market prime rate indexes may have an effect on your personal finances, such as when you take out a mortgage.
Money basically flows into and out of U.S. capital and investment markets from all over the world. The mortgage lender considering your loan application may be making a loan of money to you from funds it obtained on the London market or directly from a London bank. If your mortgage lender borrowed money from a capital investor charging a prime rate based on the Libor, the money it lends you may come with an interest rate slightly higher than those based off the U.S. prime rate, for instance. The Udemy course Banking Fundamentals ably explains the ins and outs of high finance as it’s carried out among U.S. and foreign banks and within the global financial markets.
Affect on Your Personal Financial Health
On a personal finance level, being able to make a reasonable prime rate forecast also becomes important in many circumstances. For instance, if you’re thinking of applying for a mortgage loan, accurately assessing your credit score and then understanding the prime rate comes in very handy.
If your personal credit is poor, the interest rate you could be charged to borrow money to purchase a house may be relatively high, such as at “subprime” levels. A subprime loan is one that’s normally several points above the prime rate. A typical subprime mortgage loan may cost you many thousands of dollars worth of additional interest over the life of your loan. You could even end up borrowing money from what’s called a “private money lender” at seriously high short-term interest rates.
In reality, the prime interest rate affects almost every part of your personal financial health. If you have an Individual Retirement Account the interest it earns is based off the prime rate. Part of the growth of your 401(k) retirement account depends on what the prime interest rate is. In times when the prime rate is very low, the interest earned by savings accounts as well as IRA and 401(k) or other similar retirement plan accounts also tends to be low.
A bank, for example, may make a prime rate forecast that predicts low interest rates and will then adjust downwards the interest rates it pays savers. The Life Happens: Personal Finance from College to Career course offered by Udemy clearly lays out the importance of the cost of borrowing money to your personal finances.