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Can you explain what the prime interest rate is and how it affects my credit cards?

By , CardRatings contributor
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When you hear journalists or credit card companies talk about the "prime rate," they're talking about the annual percentage rate that banks charge their very best customers when they need to borrow money. Those banks' very best customers aren't consumers like you or me, though. They're other banks.

Don't worry, though. Your bank's not trying to cover the electric bill at your corner branch. Banks lend cash to each other to balance their books on a daily basis.

In the United States, the Wall Street Journal publishes a prime rate that's based on a survey of the country's ten largest banks, based on their assets. Most of the time, those banks simply tack on about 3 percentage points to the federal funds rate, the APR they'll pay to the government when they need to borrow cash from the Federal Reserve. Just in case one or two banks doesn't fall into lockstep, the Journal publishes the rate agreed upon by seven or more of those big banks.

At one point, banks discovered that consumers love fixed rate credit cards. However, as market forces drove the prime rate higher, some issuers found themselves charging cardholders smaller finance charges than they had to pay when borrowing cash from their peers.

To prevent themselves from losing any more money, most banks stopped offering fixed rate cards. Instead, nearly every credit card uses an "APR spread." Like any good retailer, they're marking up the interest rate they're getting charged by adding a percentage to the prime rate. That way, if the prime rate rises, so does your card's interest rate.

Under those conditions, the bank never loses money. However, you could lose big if an economic upswing causes the prime rate to soar. Suddenly, your 12 percent APR card could hike itself up to 20 percent or higher, and the only notification banks have to provide is a small line item on your monthly statement. Although you can sometimes find a special offer for a fixed rate balance transfer from credit unions like Pentagon Federal, the best way you can insulate yourself from prime rate volatility is to pay down any outstanding balance before rates rise again.

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