As the mortgage market fluctuates and interest rates continue to rise, you may be hearing more people talking about Prime. So what is it exactly, and how does it affect the average consumer?
In Lending, Prime refers to the prime interest rate. It is the rate of interest that banks use to determine the basis, or starting point for consumer loans like credit cards, Heloc’s, car loans and even personal loans. For instance, a Heloc interest rate for someone with good credit might be Prime + 1%. As of today, Prime is set to 4%, so the starting interest rate on that Heloc would be 5%, and would adjust up or down as the Prime rate fluctuates. In fact, the majority of adjustable-rate loans, including mortgages, are either tied to or influenced by Prime.
You may be wondering, well, who decides what Prime is? Prime is based off the federal funds rate, which is set by the Federal Reserve. It is also influenced by the Cost of Funds Index (or COFI). Now notice that I used the word “influenced” and not “based off of”. This is because COFI is used simply as a benchmark to determine what the Prime rate could be, but it does not directly determine what that rate is. It is merely one of the factors that go into the equation.
Another good question to ask is - does Prime ever change? And the answer to that is a resounding “yes”! Every 6 weeks the Federal Reserve meets to discuss and evaluate the economy and determine if Prime should be adjusted, up or down, in order to encourage borrowing or, in the case of inflation, to slow down the rate of spending. And this is where COFI comes into play by influencing the equation used by the Federal Reserve in order to keep the economy in check and money flowing at healthy levels.
Historically, though the Federal Reserve evaluates Prime every 6 weeks, it only changes on average about once per fiscal quarter. And when it does change, it is typically in increments of a quarter of a percent. For instance, in December of 2015, Prime was at 3.5%. By December of 2020 it was at 5.50%. And now it is back down to 4%.