When the media covers topics on banking or the economy, the term “Prime Rate” is typically referenced. These reports often lead consumers to draw a connection between decisions made at the Federal Reserve and changes to prime-based products such as HELOCs, personal loans, and other types of borrowing. While there is a connection between the two, The Fed doesn’t directly determine the "Prime Rate." Let's take a closer look at how prime is determined and how changes to prime can impact HELOC rates.
Finance professionals often refer to the Prime Rate as "Prime" or the "Prime Lending Rate." The Prime Rate is the interest rate commercial banks offer to their most creditworthy customers. The federal funds rate, which the Federal Reserve Board (the Fed) sets, serves as a basis for the prime rate. The federal funds rate is the interest rate commercial banks charge each other for overnight lending. Generally, the prime rate is about 3% higher than the federal funds rate. That means that when the Fed raises or lowers the federal funds rate, the prime rate will likely increase or decrease accordingly.
Banks typically use the prime rate as published in the Wall Street Journal (WSJ) as an index to set rates on certain loan products. These include mortgages, auto loans, credit cards, and home equity lines and loans. Banks will add a margin to an index to determine the rate charged to a consumer. The margin may be negative (the rate will be below prime) or positive (the rate will be above prime.)
It may be more accurate to say that the prime rate is not determined but is influenced.
When the Fed raises or lowers the federal funds rate, lending institutions usually adjust accordingly. So, although The Fed doesn’t necessarily set the prime rate, its actions ripple across the banking sector.
When the media references The Fed as raising or lowering the prime rate, they are skipping a few steps. A practical understanding of the process is when The Fed makes changes to the federal funds rate, the banking industry makes interest rate adjustments based on those decisions.
Most lenders use the Prime Rate published in the WSJ, as the index plus or minus a margin to determine the HELOC rate. For example, Prime (the index) plus 1% (the margin) or Prime (the index) minus .5% (the margin). In addition to other terms and conditions, lenders must disclose the index and margin that will be used to calculate the interest rate. This interest rate is used to determine the monthly HELOC payment.
When prime changes, variable HELOC rates offered to new customers may change overnight. The interest rate on existing HELOCs usually change once a month, which may result in a lag time depending upon the day of the month prime changed. Typically, HELOC rates change once a month (date set by the lender) based on The Prime Rate as published in the WSJ on the last business day of the previous month.
Some HELOC special offers start with a promotional rate that may be fixed or have a lower margin for a specific period of time. Most promotional rates require the borrower to withdraw a certain amount of funds at closing and to maintain an outstanding balance for a set period, along with other requirements such as enrolling in auto pay and/or assessment of an early close-out fee. The specifics can vary by lender.
Here are some examples:
Prime plus 1%:
If Prime Rate is 3.25%, HELOC rate would be 3.25% + 1% = 4.25%
Prime minus .5%:
If Prime Rate is 3.25%, HELOC rate would be 3.25% - .5% = 2.75%
Promo Rate* Prime + 0% first 12 months, then Prime plus .75% thereafter
Months one through twelve = Prime Rate at that time.
On the thirteenth month and thereafter = Prime plus .75 %. If Prime Rate is 4% at this time, HELOC rate would change to 4% + .75% = 4.75%.
* If you are considering a HELOC promotional rate offer, it's important to make sure you know and clearly understand the requirements. What is required to obtain the special rate and what happens if you cannot fulfill this requirement, the length of time it will last, and what happens after the promotional period ends?
Understanding what Prime Rate is, how it's determined, and how it impacts HELOC rates is important knowledge when comparing different offers or if you are considering refinancing with cash out versus applying for a HELOC. When making these decisions, don't forget about the flexibility a Home Equity Line of Credit can offer.
A HELOC operates like a line of credit, letting you draw on the funds when needed, and as you pay back the principal, the funds become available to reuse during the draw period (10 - 15 years.) Payments are only made on outstanding balances. If you don't use it, you don't pay for it, but it's there if you need it. Another flexible benefit of a HELOC is the ability to use the funds for multiple things such as debt consolidation, home improvements, educational expenses, major purchases, or an emergency fund. What's more flexible than that?
A Middlesex Federal Home Loan Specialist can explain the options and discuss whether you may benefit from the flexibility a Home Equity Line of Credit offers.
To explore more factors like the prime rate that affect your HELOC rate, review our "Top 12 Home Equity Line of Credit (HELOC) Questions Answered" complete guide!