What is a 'Reference Rate'
A reference rate is an interest rate benchmarkÂ used to set other interest rates. Various types of transactions use different reference rate benchmarks, but the most common are theÂ LIBOR, the prime rate, and benchmark U.S. Treasury securities.Â Reference rates are useful in homeowner mortgages and sophisticated interest rate swap transactions made by institutions.
BREAKING DOWN 'Reference Rate'
Depending on the writingÂ 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 (CPIÂ or as a measure of economic health, such as theÂ unemployment rateÂ 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 definiteÂ financial impact. If the reference rate makes a sudden move upward, borrowers who pay floating interest ratesÂ canÂ see their payments rise dramatically.
Reference rates also form the benchmark for an interest rate swap.Â In an interest rate swap, the floating reference rate is exchanged by one party forÂ a fixed interest rate or a set of payments.Â The reference rate willÂ determine the floating interest rate portion of the contract.
How it Works
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 meansÂ the interest rate for the loan equals the prime rateÂ 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 rateÂ also goes up. Adversely, when the prime rateÂ 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.Â It helps them avoid overpaying for a loan if prime rates happen to go down after finalization of the loan.
The consumer price index is the reference rate for Treasury InflationProtected 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 a basis of a fixed rate applied to the underlying principal. Calculation of interest uses the adjusted principal multiplied by onehalf of the interest rate. On maturity, the U.S. Treasury will pay either the original or an adjusted principal, whichever is higher.Â

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