People watch the prime rate because that directly affects consumer interest rates, but the actual number to watch is the federal funds rate. The difference between the two rates is the federal funds rate is what banks charge each other to cover reserves needed as bank books close on a given day. This allows financial institutions to meet requirements for liquidity. In contrast, the prime rate is what banks charge their least risky consumers.
The Federal Reserve sets the federal funds rate; the market sets the prime rate. As Investopedia explains:
- While most variable-rate bank loans aren’t directly tied to the federal funds rate, they usually move differently. That’s because the prime and LIBOR rate, two important benchmark rates to which these loans are often pegged, have a close relationship with federal funds.
- In the case of the prime rate, the link is particularly close. Prime is usually considered the rate that a commercial bank offers to its least risky customers. The Wall Street Journal asks 10 major banks in the United States to charge their most creditworthy corporate customers. It publishes the average daily, although it only changes the rate when 70% of the respondents adjust.
Why a discourse on the federal funds rate and the prime rate? Because it looks like the prime rate will soon rise. And with inflation starting to brew, it is likely to expect the ability to repay issues in consumer credit. In short, all those excellent credit metrics that you have read about may soon deteriorate. That’s bad news for bank card profitability and worse news for the consumer with debt obligations.
My favorite site to track the prime rate is JPMC’s listing. Take special note of the rates in 1989, when the prime was a whopping 11.50%. That same period was a trigger point for U.S. credit cards. Since banks earn interest income based on the difference of what they pay for their money and what they charge customers, fixed interest rates on credit cards were vulnerable to rising interest rates. To protect against diminishing margins, bank card issuers now use the prime rate + X. X is usually a factor of risk-based pricing.
For example, Chase disclosures that the Annual Percentage Rate will be the prime plus a margin for the Chase Freedom card. In this case, Chase adds a margin of between 6.74% to 20.49% to the prime rate of 3.25%. In short, if you are a highly qualified customer, you will pay a lower rate. If you have less than average FICO Scores, you will likely pay the full freight of 23.74%. There are no secrets-pricing is risk-based. There is a margin that varies based on how you qualify.
This translates into how much a consumer pays each month and how much interest will be repaid over the life of a loan. On a typical $5,000 revolving card balance, using Chase’s rates, our math says that the interest paid for the best rate in a 30-day billing cycle would be $41.05. For the least qualified, the number would be $97.56. Start rolling the obligation up with multiple credit cards in the household, translating to a significant number when 50 or 100 basis points add to the current burden.
Here, now the news, as Roger Grimsby would say.
CNBC reports, “The Fed moves up its timeline for rate hikes as inflation rises.” Fox Business notes that we should expect a decline in stock futures, and Morningstar notes that interest rates are top on investor minds today.
We say, watch out for the consumer. They will be facing the perfect storm with rising prices, rising interest, and falling 401k accounts. That will disrupt the balance and affect consumer credit delinquency flow rates.
Overview provided by Brian Riley, Director, Credit Advisory Service at Mercator Advisory Group
