How Does the Prime Interest Rate Affect my Loan Rates

The national prime interest rate is set by the Federal Reserve to control the flow of money into the credit market. The prime interest rate is what banks charge each other for loans. During a recession, the Federal Reserve Chairperson typically lowers the interest rate in order to curb inflation and encourage borrowing. When this happens, the effects will trickle down to the consumer. 

Banks Need Loans to Lend

The first thing a consumer needs to understand when considering how the prime interest rate affects a commercial or personal loans is that banks need cash in order to make loans. Often, banks will have that cash as a result of other lender or investment practices. In an economic boom, banks may have a cash surplus that allows them to make more loans than normal. However, in a recession or even a stale economy, banks will often be short on cash. Other borrowers will default, and banks will lose money as this occurs. They may also lose money on investments they have in the stock market.

This means they need to go to other banks or the Federal Reserve to take loans. When banks take loans, they are charged the prime interest rate. This is regulated by the Fed because it has a direct impact on the rates banks will charge consumers and how many loans banks will make. As a whole, the act of banks taking loans and then making loans is called the credit market. The nation needs a healthy credit market to be profitable, and the Fed attempts to keep the market healthy. 

Banks Charge a Mark Up

Once banks have the financing they need to get cash for loans, they can accept loan applications. They will charge a mark up on these loans above the rate they are being charged by their lenders. This is how banks make money on loans; they act as a middle-man between large finance institutions and small consumers like you. 

The amount of mark up the bank charges is only partially reliant on the prime interest rate. Banks will also decide on your interest rate based on how attractive you are as a borrower. Borrowers who have a good record of paying off loans and debt are considered low risk, and they have a high credit score as a result. Banks will charge these borrowers less. When a borrower has a bad financial history, that borrower will also have a bad credit score. This means banks will charge these borrowers much more for their loan.

 

 


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