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How Do Banks Change Rates Based on Prime Rate?

by Tim Plaehn, studioD

Banks use the prime rate as a base or index rate for several types of loans, including home equity lines of credit. With a prime rate-based equity loan, you have a variable interest rate that will change if the nationally followed prime rate moves up or down. Your actual interest rate depends on the spread over prime stated in your loan contract.

Changing the Prime Rate

Since 1994, the prime rate has been set at 3 percent above the Federal Funds Target Rate, often called the "fed funds rate." The fed funds rate is used by the Federal Reserve bank as the rate commercial banks are charged to borrow short-term from the Fed. If the fed funds rate changes, the prime rate immediately moves by the same percentage amount. For example, if the fed funds rate goes from 1 percent to 1.5 percent, the prime rate would change from 4 percent to 4.5 percent.

Rate Change Timing

The fed funds rate is set by the Federal Open Market Committee of the Federal Reserve Board. The committee meets every six weeks, and at the meetings it votes on the level for the fed funds target interest rate. As a result, the current prime rate can change only once every six weeks, after the committee makes its rate announcement. Historically, the fed funds rate is changed in one-quarter of 1 percent increments, if the committee decides to make a change to the rate.

Equity Loan Rate Margin

When you get approved for a home equity line of credit, the rate will be the prime rate plus a percent margin based on your credit situation. So if the prime is 4 percent and your HELOC margin is 2.5 percent, you would pay 6.5 percent currently on the loan. If the prime moves up or down, so will your HELOC rate. The bank may have the right to change your margin rate amount if certain events occur, such as a late or missed payment.

Higher Rates Possible

At the end of 2008, the Federal Open Market Committee lowered the fed funds rate to a target of zero to 0.25 percent -- effectively zero percent interest. The prime rate went to 3.25 percent at that time. Through at least the end of 2013 and forecast to last as long as into 2015, the Fed expected to keep rates near zero, leaving the prime rate at 3.25 percent. If and when rates do start to change, the only way for the prime rate to move would be up.

About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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