Indexed Rate

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 an indexed rate include the prime rate, LIBOR, and various U.S. Treasury bills and notes rates.

Understanding an Indexed Rate

Loans and other forms of lending have interest rates associated with them. Many interest rates are fixed. When a financial product includes an indexed rate, it means that the interest rate is variable and will fluctuate with the benchmark that it is pegged to. Variable interest products can be offered at the indexed rate or they may be offered at a fully indexed rate that 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.

Popular Benchmarks for Indexed Rates

Generally, a lending institution or credit product will determine and disclose the specific benchmark used in an indexed rate product. While borrowers typically cannot choose the indexed rate for a specific product, they can compare the benchmarks used for loans at various institutions.

Prime Rate

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. It is the London InterBank Offered Rate; the rate at which London banks would lend to one another. LIBOR is calculated and administered by the ICE Benchmark Administration. This entity facilitates the calculation and production of 35 different LIBOR rates daily that can be used for a wide range of credit products.

According to an announcement by the Federal Reserve in November 2020, banks should stop writing contracts using LIBOR by the end of 2021. The Intercontinental Exchange, the authority responsible for LIBOR, will stop publishing one week and two month LIBOR after December 31, 2021. All contracts using LIBOR must be wrapped up by June 30, 2023.

Treasuries

The different yields on U.S. Treasuries are also a popular benchmark for interest rates. Credit products can be indexed to Treasuries of various maturities, providing a different yield and therefore a different rate.

Indexed Rates on Mortgages

When a mortgage has an indexed rate instead of a fixed rate, it is known as an adjustable-rate mortgage. An adjustable-rate mortgage can be beneficial or detrimental to a homeowner. After the initial introductory period, the interest rate on the mortgage will change to that of the prevailing price of the index. If the rate has gone up, a homeowner will end up paying more for their mortgage, whereas if the rate goes down, a homeowner will benefit from lower rates. It is a gamble to take on an adjustable-rate mortgage as it can be tough to predict what the economic conditions will be like in the future. A homeowner must ensure that they will be able to continue paying their mortgage if the rate increases.

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. The spread represents the risk associated with the borrower. Often, the spread on a variable rate credit product will remain the same. Therefore, the borrower’s variable interest rate will change but the same rate when the underlying indexed interest rate changes.