How does the prime interest rate affect you?

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If you read your credit card’s fine print, you might have noticed something like the following phrase: “This APR will vary with the market based on the prime rate.” What does that mean? Well, most credit cards offer what is called a variable APR—that is, an annual percentage rate of interest that varies over time as the prime rate changes. If the prime rate goes up, your credit card interest might increase by a couple of percentage points. Likewise, if the prime rate goes down, it might drop by a few points.

How does the prime interest rate affect you? Not only will you experience small fluctuations in credit card interest rates over time as your variable APR shifts, but the prime rate can also help determine the interest rate you get when you apply for a new credit card or loan.

The prime interest rate can be a little confusing, so we’re going to break it down for you. Let’s take a close look at what the prime rate is, how the prime rate is determined and how the prime rate affects the interest you pay on your various lines of credit.

What is the prime rate?

The prime interest rate helps banks and lenders decide how much interest to charge for consumer credit products like mortgages, personal loans and credit cards. In some cases, the prime rate is the interest rate offered to the most creditworthy applicants. In other cases, banks and credit issuers charge their best customers the prime interest rate plus a certain amount or percentage. The extra interest helps cover the cost of lending money, and it also protects the bank or lender from consumers who default on their loans.

If you have good credit or excellent credit, you have what is considered a “prime credit score” and are likely to be offered lower interest rates as a result. If your FICO credit score is below 670, your credit is considered “subprime.” People with fair credit or poor credit are likely to pay higher interest rates on credit cards and loans due to their subprime credit rating.

The current prime rate is 3.25 percent, but that doesn’t mean that people with prime credit should expect to only pay 3.25 percent APR on their credit cards. Credit card issuers determine interest rates using the prime rate as a baseline. Current credit card interest rates average around 16 percent—which means that even people with perfect credit scores will pay quite a bit more than the prime rate on their credit cards.

How is the prime rate determined?

The prime rate is generally three percentage points higher than the federal funds rate, which is an interest rate set by the Federal Reserve Board and used to determine how much interest banks should charge each other when making overnight loans to fulfill reserve requirements.

All banks are required to have a certain amount of cash in reserve at the end of each business day, to ensure that consumers can withdraw money from their accounts as needed. If banks need a little extra cash to fill out their reserves, they can borrow it from the Federal Reserve (or from another bank) at the federal funds interest rate.

When the Federal Reserve raises or lowers the federal funds rate, the prime rate usually responds accordingly.

How does the prime rate affect your interest rate?

Most credit cards offer a variable interest rate (often called a “variable APR”) based on the prime interest rate. This means that your credit card APR can go up or down depending on the prime rate. Credit card issuers are not required to notify you when your variable interest rate changes due to the prime interest rate, but don’t worry—in most cases, any adjustment to your interest rate will be minor.

If you want to keep track of the way your variable APR fluctuates over time, pay attention to your monthly credit card statements and see if you notice any changes. You might see your interest rate go up or down by a few percentage points, which represents the effect of the prime rate on your variable APR. (If your bank or lender wants to raise your credit card interest rate for any other reason, such as to issue a penalty APR after a late payment, they are required to give you 45 days notice.)

Some mortgages and personal loans may also offer variable interest rates. If you don’t want the interest rate you pay on your mortgage or loan to change over time, you can shop around for a fixed-rate mortgage or loan. Fixed interest rates remain constant throughout the entirety of your loan, which means you’ll always know how much interest will be charged on your balance.

Bottom line

The prime rate is the benchmark used to determine the interest rates you’ll pay on loans, credit cards and other lines of credit. That said, your creditworthiness also plays a major role in determining the interest rates lenders offer you. If you want to pay the lowest interest rates possible on your credit cards and loans, focus on building your credit score—not on what the prime rate is doing.

When the prime rate changes, you might see a small increase or decrease in your variable interest rates, but in most cases, you won’t even notice the change unless you read your credit card statements every month and compare your interest rates over time.