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Explaining the prime rate
Can you tell me who sets the prime rate and how often it adjusts?
September 9, 2002: 2:44 PM EDT
By Walter Updegrave, CNN/Money Contributing Columnist

NEW YORK (CNN/Money) - I have a home equity line of credit with an interest rate tied to the prime lending rate. Can you tell me who sets the prime rate and how often it adjusts?

-- Jason Fowler, Louisville, Kentucky

No one sets the prime rate. In fact, if you want to get technical about it, there is no "official" prime rate at all, although the Wall Street Journal publishes a consensus prime rate based on a survey of large lenders and that's the rate home equity lines are typically linked to. (You can find the rate in the "Money Rates" box in the Money & Investing section of the Journal each weekday, or you can get it online by clicking here.)

Essentially, the prime lending rate is the rate banks charge on loans to their best corporate customers. (Peons like you and me usually, though not always, pay more, of course.) And since not all banks face the same expenses -- and some banks may be more eager to make loans than others -- the prime lending rate charged by one bank can differ from the prime rate charged by another.

As a practical matter, however, most large banks -- and even many smaller ones -- tend to have the same prime rate. And they tend to raise and lower their prime rates at the same time and by the same amount. I suppose you could look at this behavior and assume there's some sort of collusion going on -- you know, bankers meeting in a smoke-filled room and agreeing on a prime rate that will guarantee them a fat profit margin. But the fact that the prime rate doesn't vary too much from bank to bank doesn't really mean all that much when it comes to the interest rate borrowers pay.

Why? Well, just because several banks have the same prime rate doesn't mean they'll charge the same rate for a loan to the same borrower. One bank may charge prime, another bank may charge prime plus one-half a percentage point, while another could charge prime plus 1 percent. Prime is used as a pricing mechanism, a base from which each bank can set its loan rates after looking at factors such as the demand for loans, the credit quality of the borrower and the banks' desire to add loans to its portfolio.

Why does the prime rate change?

So what, then, accounts for movements up and down in prime? Well, the prime is largely supposed to track the current level of short-term interest rates. The idea is that, in order to make a profit, banks borrow short-term funds at one rate (their "cost of money") and lend that money out at a higher rate. So, theoretically, the prime could vary every day with short-term rates.

As a practical matter, however, banks change their prime only when the Federal Reserve Board raises or lowers its target federal funds rate. In fact, prime typically moves in lock step with movements in the fed funds rate, going up or down by exactly the amount the Fed raises or lowers prime. Between January and December of last year, for example, the Fed lowered the fed funds target rate 11 times, taking it from 6 percent to 1.75 percent, a drop of 4.25 percentage points.

Over that time prime also declined 11 times and dropped 4.25 percentage points, going from 9 percent to 4.75 percent. Coincidence? I don't think so. In fact, you can be pretty sure that when the Fed raises the Fed funds target rate -- which it will at some point in the future, although I have no idea when -- the prime rate will increase in tandem, almost as if the two rates are doing a Fed funds-prime rate tango.

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So that's how the prime rate is determined. Be aware, though, that even if your home equity line's interest rate is pegged to prime, you shouldn't assume that it will track the prime rate exactly. Some home equity lenders may have a lag period built into their loans, so the rate charged each month may be for the prime rate in effect 45 or 90 days go.

Others may have floors, so that the rate on your loan falls with the prime rate, but not below a certain minimum rate. So if you want to be sure that you're being charged the correct rate, call your lender or check your loan agreement for details on exactly how the rate is determined.

Walter Updegrave is the author of "Investing for the Financially Challenged" and can be seen regularly Monday mornings at 8:40 am on CNNfn.  Top of page

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