What Is a Reference Rate?
Let me explain what a reference rate is—it's an interest rate benchmark that sets the foundation for other interest rates. You'll see different types in various transactions, but the most common ones are the Fed Funds Rate, SOFR, the prime rate, and rates on benchmark U.S. Treasury securities.
These reference rates come into play in everything from homeowner mortgages to complex interest rate swap deals handled by institutions.
Key Takeaways
- The term reference rate means the benchmark rate that other interest rates are tied to.
- A typical reference rate could be SOFR, applied in interest rate swaps or agreements.
- Before 2022, LIBOR was the go-to London inter-bank lending rate for many interest rates, but it got replaced by the Secured Overnight Financing Rate, known as SOFR.
- Reference rates appear in adjustable-rate mortgages (ARMs), where the borrower's rate is the reference rate—often the prime rate—plus an extra fixed amount called the spread.
How a Reference Rate Works
Depending on how a security or financial contract is written, the reference rate can get tricky to grasp. This is especially true if it's based on something like an inflation benchmark such as the Consumer Price Index (CPI), or measures of economic health like the unemployment rate or corporate default rate.
Reference rates are fundamental to adjustable-rate mortgages (ARMs). In an ARM, your interest rate as the borrower is the reference rate, usually the prime rate, plus a fixed additional amount called the spread. From the lender's side, this reference rate acts as a guaranteed borrowing rate, ensuring they at least earn the spread as profit. For you as the borrower, shifts in the reference rate can directly affect your finances—if it jumps up suddenly, your floating rate payments could increase sharply.
Reference rates also serve as the benchmark in interest rate swaps. In such a swap, one party trades the floating reference rate for a fixed interest rate or a series of payments, with the reference rate setting the floating part of the deal.
Reference Rate Example
Consider this scenario: you're a homebuyer needing to borrow $40,000 for a new home. The bank offers you a variable interest rate loan at prime plus 1%. That means your loan's interest rate is the prime rate plus 1%. So, if the prime rate is 4%, your mortgage rate becomes 5% (4% + 1%). Here, the prime rate is the reference rate.
The bank might reset the rate periodically as the reference rate changes. If the prime rate rises, your rate rises too. On the flip side, if the prime rate drops, your payment rate decreases. This reset mechanism helps the bank avoid losses from a potential default if rates shift unfavorably. As a borrower, you benefit from it too, preventing overpayment if prime rates fall after your loan closes.
Another example is the Consumer Price Index serving as the reference rate for Treasury Inflation-Protected Securities, or TIPS. These are U.S. Treasury securities tied to inflation to shield investors from its negative effects. TIPS pay interest every six months based on a fixed rate applied to the underlying principal. The interest calculation uses the adjusted principal multiplied by half the interest rate. At maturity, the U.S. Treasury pays the higher of the original or adjusted principal.
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