Reference Rate: What It Is, How It Works, Example

What Is a Reference Rate?

A reference rate is an interest rate benchmark used to set other interest rates. Various types of transactions use different reference rate benchmarks, but the most common include the Fed Funds Rate, LIBOR, the prime rate, and the rate on benchmark U.S. Treasury securities. 

Reference rates are useful in homeowner mortgages and sophisticated interest rate swap transactions made by institutions.

How a Reference Rate Works

Depending on the writing of a security or financial contract, the reference rate can be harder to understand. Difficulties happen especially if the rate is in the form of an inflation benchmark, such as the Consumer Price Index (CPI or as a measure of economic health, such as the unemployment rate or corporate default rate.

Reference rates are at the core of an adjustable-rate mortgage (ARM). With an ARM, the borrower's interest rate will be the reference rate, usually the prime rate, plus an additional fixed amount, known as the spread. From the lender's viewpoint, the reference rate is a guaranteed rate of borrowing. At a minimum, the lender always earns the spread as profit. For the borrower, however, changes in the reference rate can have a definite financial impact. If the reference rate makes a sudden move upward, borrowers who pay floating interest rates can see their payments rise dramatically.

Reference rates also form the benchmark for an interest rate swap. In an interest rate swap, the floating reference rate is exchanged by one party for a fixed interest rate or a set of payments. The reference rate will determine the floating interest rate portion of the contract.

Reference Rate Example

Let's say a homebuyer needs to borrow $40,000 to help finance the purchase of a new home. The bank offers a variable interest rate loan at prime plus 1%. That means the interest rate for the loan equals the prime rate plus 1%. Therefore, if the prime rate is 4%, then your mortgage carries an interest rate of 5% (4%+1%). In this case, the prime rate is the reference rate.

The bank may "reset" the rate from time to time as the reference rate fluctuates. When the prime rate goes up, your rate also goes up. Adversely, when the prime rate falls, so does your payment rate. By allowing the bank to "reset" the rate, it avoids the chance that the borrower may default on the loan, which causes the bank to lose money. Borrowers also benefit from a "reset" of rate. It helps them avoid overpaying for a loan if prime rates happen to go down after the finalization of the loan.

The consumer price index is the reference rate for Treasury Inflation-Protected Securities, known as TIPS. TIPS are U.S Treasury securities that are indexed to inflation to protect investors from the counteractive effects of inflation. TIPS will pay interest every six months using the basis of a fixed rate applied to the underlying principle. Calculation of interest uses the adjusted principal multiplied by one-half of the interest rate. On maturity, the U.S. Treasury will pay either the original or an adjusted principal, whichever is higher.