If you ever read the news online or in newspapers or magazines, chances are good that you have heard mention of the prime rate, the Federal Funds rate, and various other rates in conjunction with home mortgage loans. Mortgage rates are influenced by the prime rate and other major indexes; to understand exactly what these are, read on.
The prime rate generally refers to the Wall Street Journal (WSJ) Prime Rate, which is the United States Prime Rate that is printed monthly in the Eastern edition of the WSJ newspaper. To determine the current Prime Rate, the WSJ conducts a poll of the ten largest U.S. Banks. The prime rate remains the same until a minimum of seven of the top ten banks have changed their prime rate, at which time the WSJ Prime Rate is adjusted upward or downward.
The prime rate is used by U.S. lenders for both commercial and consumer credit products; most mortgage lenders start with the current prime rate and add a profit margin that is primarily determined by the amount of risk associated with the credit product. Mortgage rates, especially adjustable rate mortgage rates, are very sensitive to changes in the prime rate, as are credit card interest rates and rates for other commercial and consumer loan products.
The Federal Open Market Committee, which is part of the Federal Reserve System, sets the Federal Funds Rate; it is defined as the rate at which U.S. banks lend money to one another on a short-term basis, usually overnight. If this rate falls, economic growth can be stimulated, but caution is required or inflation may result. If the Federal Funds Rate rises, inflation pressures can be quelled but at the expense of economic growth.
The rate at which financial institutions borrow funds from a Federal Reserve Bank is known as the Federal Discount Rate. Each Federal Reserve Bank's Board of Directors determines this rate every fourteen days. Like the Federal Funds Rate, the Federal Reserve uses the Federal Discount Rate to control the supply of funds; this has implications for economic growth, inflation, and commercial and consumer interest rates. Short-term interest rates respond quickly to changes in the Federal Discount Rate; an increase in the Federal Discount Rate triggers a rise in short-term interest rates, including mortgage rates, and a reduction in the Federal Discount Rate results in a corresponding drop in short-term interest rates.