If you are shopping for a new credit card, an education loan, a car loan, a business loan, a personal loan or a specific type of second mortgage called a home equity line of credit (HELOC) then you need to understand how the U.S. Prime Rate works.

On Wall Street and throughout the worldwide banking community, the U.S. Prime Rate is understood as the interest rate at which banks lend money to their most creditworthy business customers. Most American banks, credit unions and other lending institutions use the U.S. Prime Rate as an index or base rate for numerous loan products; a margin is added to the Prime Rate depending on how risky the lending institution feels the loan is: the riskier the loan, the higher the margin. However, since the Prime Rate is an index and not a law, business owners and consumers can sometimes find loan products that have an interest rate that's below the U.S. Prime Rate, especially if the loan in question is secured.

The U.S. Prime Rate is determined by adding 300 basis points (3.00 percentage points) to the federal funds target rate (also known as the fed funds target rate.) So if the fed funds target rate is 2.25%, then the U.S. Prime rate will be 5.25%.

The federal funds target rate is America's most important short-term interest rate, and it is controlled by a group within the U.S. Federal Reserve system called the Federal Open Market Committee (FOMC). The FOMC convenes a monetary policy meeting eight times every year to decide whether to raise, lower or make no changes to the fed funds target rate. The FOMC may also hold an emergency meeting at any time, if economic conditions warrant.

If the FOMC determines that the pace of inflation within the U.S. economy is too high, then the group is more likely to raise the fed funds target rate, so as to bring inflation under control. Conversely, if the FOMC determines that numerous sectors of the U.S. economy are flagging in a significant way, or if the economy is determined to be in recession, then the group is more likely to lower the fed funds target rate, so as to spur economic growth. If the U.S. economy is growing at a moderate pace and inflation is also rising at a moderate rate, then the FOMC is more likely to make no changes to the fed funds target rate.

When it comes to borrowing money, timing is very crucial, so it's important for consumers and business owners to stay informed about what the FOMC is likely to do with the fed funds target rate at the FOMC's next monetary policy meeting. If the U.S. economy is showing clear signs of contraction, then holding off on a fixed-rate loan may be a good idea, since in such an economic environment, short-term interest rates, like the Prime Rate, may be on their way down. On the other hand, if the U.S. economy is growing at a very strong pace and the rate of inflation is relatively high, then borrowing via a fixed-rate loan sooner rather than later may be the smarter option, because in such an economic environment, short-term interest rates may be on their way up.

Copyright © 2008 Steve "AmCy" Brown, American CyberSpace®

The U.S. Prime Rate: A benchmark, short-term interest rate used in the banking system of the United States. The Prime Rate serves as an index or base rate for many types of loans and credit products for both businesses and consumers. The Prime Rate is invariably 3.00 percentage points (300 basis points) above the benchmark Fed Funds Target Rate. The U.S. Prime Rate is also known as the Wall Street Journal (WSJ) Prime Rate, the Fed Prime Rate and the national Prime Rate.

The Fed: The United States Federal Reserve System, which acts as America's central bank.

The FOMC: Short for the Federal Open Market Committee. Made up of seven Federal Reserve Governors plus five Federal Reserve Bank presidents, the FOMC is the group within the Federal Reserve system that makes decisions on short-term interest rates, the most potent of which is the Fed Funds Target Rate (FFTR). The FOMC meets 8 times per year to set rates, and the group may also hold an emergency meeting at any time, if an intermeeting adjustment for short-term rates is expedient.

The Fed Funds Rate: The rate at which American banks borrow overnight funds from each other, via one of the 12 regional Federal Reserve banks. The Fed sets a target for the fed funds rate, and it is this target that serves as the main benchmark interest rate for the United States. The target for the fed funds rate influences other key financial market indexes, both domestic and global, like the U.S. Prime Rate and the London Interbank Offered Rates (LIBOR).

The Fed uses the FFTR to regulate the American economy, lowering it when the economy needs a boost, and raising it when the pace of inflation is too high. The FFTR was adopted as the Fed's main monetary policy tool back in 1990.

Intermeeting Rate Adjustment: This is when the Federal Open Market Committee (FOMC) convenes an unscheduled monetary policy meeting in order to make adjustments to short-term interest rates, i.e. the Fed Funds Target Rate and/or the discount rate. This type of FOMC gathering is also called an emergency meeting.

Short-Term Rates: The short-term interest rates that are controlled by the U.S. Federal Reserve, i.e. the Fed Funds Target Rate, the U.S. Prime Rate and the discount rate.

Copyright © 2008 Steve "AmCy" Brown, American CyberSpace®