The terms "prime rate" and "mortgage rate" can be confusing to those new to the world of borrowing and banking. Actually, they're unrelated and move up or down based not on each other, but on the overall economic situation in the U.S. Therefore, monitoring one will only marginally help you predict the movement of the other. But both rates may affect you.
Prime Rate Definition
Technically, the prime rate is the interest rate commercial banks charge their best -- or prime -- borrowers. It is based on banks' cost of funds -- savings rates -- as well as availability of money, desire to make new loans and general market conditions. But it has become more than that: The prime rate is an index used to calculate other interest rates, both personal and business. For example, personal loan rates might be priced at 6 percent over prime. If prime were 5 percent, personal loans would cost you 11 percent.
Mortgage Rate Calculations
Most mortgage rates are influenced by the bond market and general competitive conditions. Since most mortgages are sold into the secondary market, usually Fannie Mae, Freddie Mac and private loan buyers, they compete with the sale of bonds. This is because both are long-term investments paying a stated interest rate. Mortgage and bond sellers compete for the same buyers, usually pension funds, insurance companies and universities. So if bond rates increase to 7 percent, mortgage lenders and/or the secondary market must increase mortgage rates to successfully compete.
Prime Rate Effects
The U.S. prime rate, as published daily in "The Wall Street Journal," is a compilation of the most prevalent rates of a targeted group of banks. It does not represent the prime rate of one commercial bank but is an index of the market. The WSJ prime rate is used as the index for numerous other loans. For example, commercial loans quoted as "prime plus 2" will cost the WSJ prime rate plus 2 percent. If you own a home and want an equity loan, your lender may also quote you a rate like "prime plus 1," meaning you'll pay the published prime rate plus 1 percent.
Primary Rate Differences
The true philosophical and operating difference in the two rates is their focus. The prime rate is designed for short-term loans, usually 10 years or less. Mortgage rates apply to long-term borrowing, typically 15 to 30 years. When the commercial and personal loan markets are active, the prime rate can change rapidly for better or worse, reflecting its short-term nature. Unless something dramatic occurs in the economy or the real estate industry, mortgage rates tend to be more stable. But in inflationary periods or times of major economic uncertainty, even these rates can fluctuate on a daily basis.