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How the prime rate works and how it affects you

The prime rate affects the interest you receive on financial products. Here's a breakdown of the current prime rate and how it's determined by credit lenders.

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The prime rate is the best interest rate you can get, and it's influenced by the economy.

When you apply for a financial product, including credit cards, personal loans and auto loans, lenders will charge you interest based on what kind of risk you pose to them. Borrowers with a prime credit score (usually 660 and above) are more likely to receive prime, or favorable, terms.

But what exactly the prime rate is fluctuates based on changes in the economy, such as a recession like the one brought about by the coronavirus pandemic.

While some factors are outside of your control, you can still be informed about the current prime rate and how banks decide on it.  Below, CNBC Select breaks down what you need to know about the prime rate and how it affects your finances.

What is the current prime rate?

The prime rate is 3.25% as of July 2020, according to the Fed. This is the lowest rate in the past year and since 2008.

How is the prime rate determined?

The prime rate isn't determined by the Fed, but instead by individual banks. However, the prime rate is influenced by something called the federal funds rate, which is set by the Federal Open Market Committee consisting of twelve Fed members.

The federal funds rate is the rate banks charge each other for short-term loans. It is currently 0% to .25%. Banks use this rate as a starting point to set the prime rate for consumers. The prime rate is often roughly 3% higher than the federal funds rate (and currently 3.25%).

The Fed meets roughly eight times a year to discuss potential adjustments to the federal funds rate, based on the economy's current conditions. For instance, the Fed announced two emergency rate cuts in March to help combat the negative economic impact of the coronavirus. These rate cuts resulted in a decrease in the federal funds rate, which in change lowered the prime rate and the interest rate for many consumer financial products.

How does the prime rate affect you?

While the interest rate on most financial products is dependent on the prime rate, the actual rate you receive is rarely the same exact amount. Typically, your interest rate is above the prime rate, but the amount can be greater depending on the lender. For instance, the average credit card APR on accounts assessed interest is currently 15.78% — the prime rate plus 12.53%.

Of course, most credit cards set variable ranges for interest rates, meaning you can receive an APR anywhere on a preset scale, such as 12% to 24%. The Blue Cash Preferred® Card from American Express has a 13.99% to 23.99% variable APR (see rates and fees). Consumers with excellent credit will likely qualify for rates as low as 13.99%, whereas someone with good credit may receive rates closer to 23.99%.

When prime rate changes (as a result of the Fed changing the federal funds rate), your credit card APR also fluctuates. The change follows the same pattern as the prime rate — meaning a decrease in the prime rate results in a decrease in your card's APR. The exact change in your interest rate depends on how much the prime rate changes — take for instance, the two recent adjustments that resulted in .50% and 1% APR reductions. A 1% decrease means a 14.99% variable APR would decrease to 13.99%. This change often takes one to two billing cycles.

Fixed-rate financial products, such as many personal loans and auto loans, won't fluctuate since you lock in your interest rate when you open the loan.

Bottom line

While the prime rate affects the interest rate lenders set for financial products, you can still influence the rate you receive by improving your credit score. The higher your credit score, the better (and lower) interest rates you'll receive on existing accounts with variable rates, as well as new account openings.

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For rates and fees of Blue Cash Preferred® Card from American Express, click here.

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the CNBC Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.