Benchmark Interest Rate - Explained
What is the Benchmark Interest Rate?
Written by J. Mance Gordon
Updated at April 18th, 2022
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What is the Benchmark Interest Rate?
A benchmark reference rate is an interest rate that determines other interest rates. There are different interest rate benchmarks used for setting other interest rates. They determine the yield, returns or pay-offs attributable to other contracts. Benchmark defense rates are used in financial contracts, mortgage contracts and even interest rates swap contracts. In the United States, there are few commonly used benchmark invest of reference rates, they include the prime rate, LIBOR, and the U.S treasury securities benchmarks.
Back to:BANKING, LENDING, & CREDIT INDUSTRY
How Does a Reference Rate Work?
Reference rates are linked to adjustable rate mortgage (ARM) in which the borrower's interest rate often serve as the reference rate. Since different benchmarks exist as reference rates, some might be difficult to understand. An interest rate in form of an inflation benchmark such as CPI (Consumer Price Index) might be difficult to understand due to its nature. Nevertheless, reference rates serve a number of purposes and benefits. For instance, a reference rate which is the interest rate of a borrower (the prime rate, plus an additional fixed amount) benefits the lender in form of a spread. If a reference rate is in form of an interest rate swap, the floating interest rate of the financial contract is determined by the reference rate. Below is an illustration of a reference rate works. Assuming a borrower borrows $40,000 as a mortgage loan and the lender offers a variable interest rate loan at prime plus 1%. If the prime is 4%, the interest rate for the mortgage will be 5% which is prime (4%) and an additional (1%). If there is fluctuation in the reference, the lender, usually a financial institution can adjust the interest rate. When there is an increase in prime rate, the interest rate increases and a decline in prime rate causes a decrease in interest rate. Treasury Inflation-Protected Securities (TIPS) protect investors from counter effects of inflation. Interests are paid by TIPS in six months interval and they are paid based on the original or adjusted principal.