What Is an Indexed Rate?
An indexed rate is an interest rate that is tied to a specific benchmark with rate changes based on the movement of the benchmark. Indexed interest rates are used in variable rate credit products. Popular benchmarks for indexed interest rate credit include the prime rate, LIBOR, and various U.S. Treasury bill and note rates.
BREAKING DOWN Indexed Rate
An indexed rate loan product is a product with a variable interest rate that generally follows credit market interest rate trends. Variable interest credit products can be offered at the indexed rate or they may be offered at a fully indexed rate which includes a spread added to the indexed rate.
Benchmarks used for calculating a basic indexed rate are usually well established in the credit market. The prime rate, LIBOR, and various rates on U.S. Treasury bills and notes can be used as an index rate. They each represent various segments of the market and are used with various maturities.
Indexed rate loans often have variable interest rates that follow credit market interest rate trends.
Popular Indexed Rate Benchmarks
Generally, a lending institution or credit product will determine and disclose the specific benchmark used in an indexed rate product. While borrowers typically can not choose the indexed rate for a specific product, they can compare the benchmarks used for loans at various institutions.
The market prime rate is an average of the prime rates offered by banks to other banks and their most creditworthy borrowers. Banks adjust their prime rate according to market conditions. The Wall Street Journal offers a prime rate based on a bank survey. Generally, loans indexed to a prime rate will be based on the bank’s individual prime rate.
LIBOR is one of the most broadly used benchmarks in the world for indexing interest rates. LIBOR is calculated and administered by the ICE Benchmark Administration. This entity facilitates the calculation and production of 35 different LIBOR rates daily which can be used for a wide range of credit products.
Treasuries are also a popular benchmark for interest rates. Credit products can be indexed to Treasuries of various maturities.
Fully Indexed Interest Rates
The indexed rate is typically the lowest rate a lender will charge to a borrower. Standard indexed rates are usually charged to an institution’s highest credit quality borrowers. Other borrowers with variable rate credit products will typically be charged a fully indexed interest rate. This rate adds a spread or margin to a base indexed rate. The spread on a credit product is usually determined by the underwriter and is based on the information a borrower provides in a credit application.
Borrowers with a higher credit score and lower debt-to-income level will have a lower spread. Lower credit quality borrowers will have a higher spread. Often, the spread on a variable rate credit product will remain the same. Therefore, the borrower’s variable interest rate will change when the underlying indexed interest rate changes.