Prime Mortgage: A Complete Guide
In the United States, borrowing is partially impacted by a number called the “Prime Rate.” This figure seems mysterious. But you can find it daily in the Wall Street Journal and other online sources. Its impact on banking, however, is significant and extends far beyond housing.
The US Prime Interest Rate is used by many banks. It helps financial institutions to set rates on many consumer loan products. These loan products include car loans, credit cards, personal loans, home equity lines of credit, and so forth. If the US Prime Rate changes, any loan product tied to the Prime Rate will also change. This can include variable-rate credit cards or certain adjustable-rate mortgages.
To learn more about a prime mortgage, it’s best to get a clear understanding of the Prime Rate.
What’s the Definition of Prime Rate?
The US Prime Rate is a commonly used, short-term interest rate in the United States banking system. All types of American banks, credit unions, thrifts, etc. use the US Prime Rate as an index or foundation rate. They use the Prime Rate to price various short- and medium-term loan products. The Prime Rate is consistent because banks want to offer businesses and consumers loan products that are both profitable and competitive. A consistent US Prime Rate is beneficial for financial institutions and individuals alike. Individuals and businesses can more easily compare similar loan products from competing lenders.
What Are the Details of the Prime Rate?
Each US state does not have its own individual Prime Rate. In other words, “Texas Prime Rate” or “New York Prime Rate” are the same as the US Prime Rate.
It's important to note that the Prime Rate is an index, not a law. It’s possible to find a loan or credit card with an interest rate less than the current Prime Lending Rate. Lenders will sometimes offer below-Prime-Rate loans to highly qualified customers as a way of generating business. Furthermore, below-Prime-Rate loans are relatively common when the loan product in question is secured. This is the case with mortgages, home equity loans, home equity lines of credit, and car loans.
How Is the Prime Rate Determined?
Every US bank sets its own Prime Rate. However, the Prime Rate is invariably tied to America's cardinal, benchmark interest rate: the Federal Funds Target Rate. The Federal Funds Target rate is also known as the Fed Funds Target Rate or FFTR.
The FFTR is set by a committee within the Federal Reserve system called The Federal Open Market Committee (FOMC). The FOMC usually meets every six weeks. During these meetings, the FOMC votes on whether or not to make changes to the FFTR.
When the FFTR changes, the United States (Fed) Prime Rate will also change. When the FOMC votes not to change to the FFTR, then the US Prime Rate also remains unchanged.
Since the second quarter of 1994, a rule of thumb for the US Prime Rate has been:
US Prime Rate = (FFTR + 3)
How Is the Prime Rate Used?
The Prime Rate is the rate that banks use when they lend to their best customers: large corporations. Everything else flows from there. Banks charge the best rates to ideal customers: those who are at low risk of defaulting. Usually, this means they offer a borrower the Prime rate plus some additional amount for profit. Lenders increase the profit percentage on top of the Prime rate for riskier borrowers.
Other types of credit are also frequently based on the Lender's Prime Rate. These can include credit cards or auto loans. Like with mortgages, these loans will be priced as Prime. Then the lender adds some amount of profit that corresponds to the borrower’s risk level. Banks don’t always disclose that they’re pricing against their Prime Rate. They may instead provide a flat number to customers, which is basically a fixed-rate loan.
Lenders who provide consumer and commercial loan products often use the US Prime Interest Rate. The Prime Rate is used as a base lending rate, with a margin (profit). This profit is primarily based on the amount of risk associated with a loan. Moreover, some financial institutions use Prime as an index for pricing certain time-deposit products like variable-rate Certificates of Deposit.
What Influences the Prime Rate?
Each bank has its own criteria for how their Prime Rate will behave. In general, some very influential factors include:
The Federal Funds Rate
Changes in other banks’ Prime Rate
Economic pressure, like a recession
Because banks set their own Prime Rate, they can also raise or reduce it at will. If a financial institution is looking to attract new customers, they might lower their Prime Rate. They do this to make all their loan products cheaper for borrowers. A lender might also offer discounted loans that are below Prime for well-qualified borrowers. Many times, those borrowers have friends and family they can tell about the bank’s great deals.
The Prime Rate is nothing more than the best rate the bank offers, except when they offer a lower rate.
What You Need to Know About Prime Rates
The Prime Rate isn’t really what you need to pay attention to. Instead, look at mortgage rates for the types of mortgages that you’re interested in exploring. These also can vary across banks, depending on how much profit they build into the loan. The Prime Rate is often an intermediate step in the mortgage pricing process and one that can really confuse the situation.
There are two major categories for loans for borrowers, prime mortgages and subprime mortgages. Subprime mortgages are designed for people with lower or blemished credit scores. As such, they are riskier for lenders and usually cost the borrower more.
What Is a Prime Mortgage?
Prime mortgages meet Fannie Mae and Freddie Mac standards. To be approved for a prime mortgage, borrowers must have a good credit history. They must also have an income of at least three to four times greater than their mortgage payments. Borrowers with credit scores in the 620 – 650 range often qualify for a prime mortgage. Borrowers with higher credit scores almost always qualify for a prime mortgage.
Most mortgages are either prime or sub-prime in character. The most common type of home loan is the fixed-rate prime mortgage. Its interest rate is stable over the life of the loan.
Why Get a Prime Mortgage?
Prime mortgages save borrowers money. This is because their low interest rates lower monthly mortgage rates by hundreds of dollars. Additionally, the down payment requirements give the new homeowners immediate equity value. Furthermore, if the down payment is high enough, the lender won’t require private mortgage insurance. That can lead to even more savings.
A prime mortgage loan meets the standards for quality mortgages set out by Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac are the two government-sponsored enterprises (GSEs) that purchase the majority of home loans. Only borrowers with good credit histories can be approved for prime mortgages. In addition to good credit scores, the borrower needs an income level three to four times greater than their mortgage payments.
What Are the Features of a Prime Mortgage?
Prime mortgage loans are offered by lenders to their best customers. They feature interest rates at least as low as the current prime rate offered by the Federal Reserve to banks. Some prime mortgages, though, feature rates considerably lower than that rate. These loans almost always require down payments from the borrower. A down payment is typically between 10 and 20 percent of the purchase price of the home.
What Are the Benefits of a Prime Mortgage?
Prime mortgages save home buyers money. A prime mortgage has low interest rates. This typically makes the monthly mortgage payment much lower than sub-prime mortgages. Also, down payment requirements on these loans give homeowners immediate equity value. If a borrower has a high enough down payment, the lender won’t require private mortgage insurance or PMI. Eliminating this monthly insurance payment leads to even more savings.
Who Qualifies for a Prime Mortgage?
Qualifying for a prime mortgage depends greatly on the state of the financial markets. When the money supply is looser, folks with credit scores from 620 to 650 often easily qualify. When it's tighter, those with scores below 690 could find themselves in subprime territory. Borrowers sometimes get around this problem by using federally backed loans, such as those from the Federal Housing Administration. FHA loans feature interest rates slightly higher than the prime rate.
What If You Don’t Qualify for a Prime Mortgage?
Currently, a low credit score is anything below 620, according to the Home Buying Institute. Borrowers with low credit scores almost never secure prime mortgages. Lenders have found that lower-score borrowers are more likely to default. To cover their risk, lenders charge such borrowers higher, or sub-prime, interest rates on their home loans.
A subprime mortgage is a mortgage loan offered to borrowers with poor credit scores. A poor credit score is usually lower than 620. Borrowers with lower credit scores are usually unable to qualify for conventional mortgages. Subprime borrowers pose a higher risk to lenders. Therefore, subprime mortgages come with higher interest rates to make up for the potential risk to the lenders. Subprime lending led to the subprime mortgage crisis in 2006.