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How an Increase in the Prime Rate Impacts You

How an Increase in the Prime Rate Impacts YOU

The term prime rate refers to the interest rate that banks charge their preferred customers or those with the highest credit ratings. It is used to determine borrowing costs on many short-term loan products. The target federal funds rate, which is set by the Federal Reserve Board, serves as the basis for the prime rate.     ~ Bankrate.com

How the prime rate works

Imagine the prime rate as a flowchart, starting first with the Federal Reserve Board, which sets the federal funds rate. This is the rate the largest commercial banks in the country (like Bank of America or Wells Fargo) lend to each other for overnight funds. The rate trickles down to the local level, in the form of short-term loan rates set by mid- and smaller-sized financial institutions, eventually reaching the consumer. For you, an increase in the fed funds rate can impact the interest you pay on variable rate loans now, future fixed-rate loans, and what you earn from deposits, share certificates, and money market funds.

Is the prime rate the same as the fed funds rate?

No. The prime rate is generally 300 basis points, or three percent higher than the fed funds rate. The Wall Street Journal (WSJ) calculates the rate daily based on the overnight corporate lending rate between the nation’s largest commercial banks. WSJ is also considered to be “the official source” many financial institutions rely on for referencing their prime rate and setting rates. (Bankrate.com)

The change in the fed funds rate can set in motion other economic changes, from fluctuating stock prices to housing, construction and employment market changes. It can also be a gauge to control inflation, to curb or stimulate the economy or encourage or limit lending.

For example, a decreasing rate can boost the credit market and economy. A rising rate can control growth to stem inflation. If the credit market is strong, the Federal Reserve may choose to raise rates. The Fed's mission is to foster economic growth without raising inflation. It also wants to maximize the labor market potential (Bankrate.com).

How a rate increase impacts you

Because the prime rate impacts most all loans, the amount and types of credit you have could be affected. The more variable rate credit you hold, the bigger the increase you could see in interest and payments.

Socioeconomic factors and demographics also play a role. Consider your age and income: If you’re in your 20s or 30s, you’re likely to be buying homes and cars and be more dependent on credit. You may have student debt. And, your income may be less. If you’re in your 40s and 50s, income levels typically are rising, and you may be investing or planning for retirement. An increase in the prime rate can affect both sides – lending and saving – and how much you pay or earn in interest.

Where you work is another consideration. Is it in an industry likely to be hit by a change in the prime rate? An example is in construction, which is reliant on the interest rate climate. If rising rates discourage growth in a particular industry, the likelihood of employment or income opportunities may decrease.

Also, what lifestyle choices have you made that are contingent upon variable rate credit? If you are beholden to large amounts of variable rate debt, you could feel the impact of a rate increase more than others.

Variable rate loans will see changes, first

Variable rates tie directly to the prime rate. Fixed rates, those set for an agreed-upon term, are influenced only indirectly. A change in the prime rate usually impacts variable rate home equity lines, adjustable rate mortgages (ARMs), and variable rate credit cards, first. Variable rate student loans may also see an increase compared to other types of loans.

When variable rates go up, so will minimum monthly payments. However, lenders are required to notify you if there are changes in your rate or payment amount. If you’re unsure how the interest is calculated on any of your loan accounts, review the terms of your credit agreement. It will state the form of interest you’re paying and how and when a lender can increase the rate. If you’re still not sure, contact the lender.

Prospective fixed-rate loans you obtain could also feel the impact, but not as soon. These loans range from mortgages, closed-end home equity loans to car loans. If you plan to apply for a fixed-rate loan, expect only minor tweaks this year, assuming rates increase incrementally. Note: car loans typically are the slowest to reflect a change in the prime rate, perhaps up to six months (USAToday.com).

Deposit rates may increase

Although deposit rates do not increase at the same pace as the prime rate, it is not unusual to see deposit rates go up a few months after a rise in the prime rate. For example, share certificates follow short-term interest rates based on the fed funds rate. Treasury yields and other economic factors can influence rates on long-term certificates as well (Bankrate.com). As the fed funds rate increases, money market accounts and mutual funds may also benefit while earnings in the equity market may decline.

To lessen your impact

  1. Keep your overall financial portfolio balanced to reduce risk
  2. If you’re risk-averse, choose fixed-rate loans over variable
  3. Have a mix of variable and fixed-rate investments
  4. Watch the market and its impact on the accounts you have
 

For now, the effect will be minor

Policymakers hint we’ll see incremental increases in the fed funds rate throughout the year, perhaps a total of 100 basis points (or one percent). Most of us won’t see an immediate impact on our finances unless we have huge amounts tied up in variable rate credit. As increases occur, loan (and some deposit) rates may start to edge up.

By understanding the prime rate, you can take control of your financial choices

Be an informed consumer. When you see how a change in the prime rate can impact your personal finances, prepare. If you’re risk-adverse, take advantage of fixed-rate products, both on the deposit and loan side. If you don’t mind risk, consider forms of variable rate credit and certain investments. But keep an eye on all of your accounts and be flexible if variable rate credit becomes costly or decreases earnings. For most of us, a balanced mix of both is the best solution.

If you have questions about rising rates and your UFCU loan and share accounts, contact us at (888) 982-1400 or visit your local branch.

Sources:

http://www.bankrate.com/finance/mortgages/prime-rate-what-is-it-and-how-is-it-set.aspx#ixzz3ztzIRy1E

http://www.finweb.com/loans/4-factors-that-affect-the-current-prime-rate.html#axzz3zuHIry4i

http://homeguides.sfgate.com/effect-prime-rate-mortgage-interest-rates-8866.html

http://www.gobankingrates.com/banking/current-prime-interest-rate-today/

http://www.usatoday.com/story/money/2015/12/14/fed-rate-hike-impact/77300960/#

http://smallbusiness.chron.com/reasons-change-prime-interest-rate-3642.html

http://www.bankrate.com/finance/mortgages/fed-affects-banks-rates-prices-and-jobs-1.aspx#ixzz3zvAOLYQi

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