Credit Cards and the Prime Rate

Most credit card issuers use the prime rate to calculate interest rates. The prime rate is defined as the interest rate charged by major banks to their "best" (meaning most creditworthy) customers.   The Federal Reserve Board increases the prime rate during periods when the economy is growing too fast to discourage inflation, and lowers it when the economy is too sluggish to stimulate growth.

The prime rate is the economic indicator used by most credit card companies to determine the interest rate charged on their variable rate credit cards (as opposed to fixed rate credit cards).  Variable rate credit cards are usually determined by adding the credit card company's margin rate (whatever percentage it chooses for a particular card offer, i.e., 2.50% for those with high credit scores; a 10% margin for those with low credit scores) to an economic indicator, which is almost always the prime lending rate.  Therefore, if your credit card company's margin on your card is 2.75% and the prime lending rate is 5.00%, your interest rate that month will be 7.75%.  If The Fed raises the prime lending rate by .25% next month, your new credit card interest rate would increase to 8.00%.  If the prime rate was lowered by .25% a few months later, then your interest rate should fall back to 7.75%.

When the prime rate decreased during the period February 2001 until the present, most credit card interest rates did not decrease accordingly.  In fact, most credit card issuers continue to raise their interest rates.  How did they do that?  When the prime lending rate fell, they simply raised their margin rates to compensate for the decreasing prime rate so they would not have to lower the interest rate on customers' credit cards.  You can find out how ethical your credit card company is by getting out your old monthly statements and seeing if your interest rate dropped as the prime rate fell steadily during the period February 2001 to the present. (Of course, to do this your credit card interest rate must be tied to the prime lending rate.)   If you have a variable rate card, notice how quickly your credit card company raised your interest rate when the prime rate increased.  Did they lower your interest rate when the prime rate fell?

Many consumers believe they can avoid a credit card interest rate increase by getting a fixed rate credit card and their interest rate will not increase or decrease; however, one should be aware that "fixed" does not mean that the interest rate cannot ever be raised.  The term "fixed" means that the credit card is not tied to an economic indicator like the prime lending rate.  Credit card companies have the right to raise fixed rates whenever they want, as they indicated in the terms and conditions provisions of the credit card when you signed up for the card, so long as they give you 30 days' written notice.   The good news is that credit card companies rarely raise the interest rate on  fixed rate credit cards unless you miss a payment or default.  Therefore, you are better off with a very low, fixed interest rate credit card than one with a variable interest rate.

Of course, since the Card Act was passed a few years ago, most credit card companies have changed from a fixed rate to a variable interest rate so that they can increase the credit card interest rate on their customers without violating the notification requirements in the Card Act, making the prime lending rate more important that ever.

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