What is a Reference Rate?
A reference rate is an interest rate that determines another interest rate.
How Does a Reference Rate Work?
Let's say you want to borrow $5,000 to start a business. Company XYZ offers you a variable interest rate loan at prime plus 5%. That means that the interest rate on the loan equals whatever the prime rate is plus 5%. So if the prime rate is 4%, then your loan carries an interest rate of 9%. The prime rate is the reference rate.
The bank may 'reset' the rate from time to time as the reference rate changes. This means that if the prime rate goes up, your rate goes up; if the prime rate goes down, your rate goes down. This helps the bank avoid losing money if the prime rate happens to go up after it has granted you the loan. It also helps you avoid overpaying for the loan if prime rates happen to go down after you take out the loan.
In another example, if your mortgage interest rate is a variable rate (that is, it is adjustable), your rate rises and falls with the market and you and your payments get to go along for the ride. This is great when rates are falling, but when rates are rising, hang on (or try to refinance into a fixed-rate mortgage).
Why Does a Reference Rate Matter?
The prime rate and LIBOR are common reference rates; the rates on Treasurys are as well. Interest rates are some of the most powerful and influential components of any economy, which is why most countries' central banks take a keen interest if not an active role in monitoring interest rates. They also affect individual, day-to-day consumer decisions, such as determining whether it's a good time to buy a house, borrow money for a college degree, or put money in the bank. After all, the higher interest rates are, the less borrowing (and thus economic expansion) takes place; the lower interest rates go, the more borrowing (and economic expansion) takes place. They affect stock prices, derivatives trading, bond markets, and the size of every investor's future nest egg.
