What Is an Indexed Rate?

Indexed Rates Explained

Definition
An indexed rate is an interest rate tied to a specific benchmark that moves up or down based on market conditions.
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An indexed rate is an interest rate tied to a specific benchmark that moves up or down based on market conditions. These types of interest rates are used with variable interest-rate products like adjustable-rate mortgages (ARMs), student loans, and home equity lines of credit. The most common benchmarks used for indexed rates include U.S. Treasury securities, the prime rate, and Libor.

Definition and Example of an Indexed Rate

An indexed rate is a type of interest rate linked to a benchmark that fluctuates based on market conditions. Indexed rates are tied to benchmarks such as U.S. Treasury bills and the prime rate. Lenders use these benchmarks to establish an interest-rate baseline for variable-rate products including ARMs, lines of credit, student and auto loans.

Note

Because indexed rates change over time, borrowers with variable-interest-rate products can expect their interest rates and payment amounts to vary from year to year.

For example, if you have an ARM, it has a variable interest rate tied to an index or benchmark— most likely the prime rate. Let’s say the U.S. prime rate suddenly goes up. Any interest rates linked to that index, including your ARM, will reflect that increase. Conversely, if the prime rate decreases, the variable interest rate on your ARM would go down.

How Does an Indexed Rate Work?

When you take out a loan, the amount you borrow is the principal balance. You also will pay an interest rate to compensate the lender for the cost of borrowing the money over time. That interest rate can be either fixed or variable. Fixed rates don’t change, whereas variable rates do.

Variable interest rates change with an index. The index is established by using one of several popular benchmarks.

Note

The most common index-rate benchmarks are the U.S. prime rate and U.S. Treasury bills and notes. Lenders decide which benchmarks to use for their indexed-rate product; borrowers can’t select benchmarks.

“The best-known example of an indexed rate most people will be familiar with is the mortgage rate they pay on their home loan,” Josh Simpson, vice president of operations and investment advisor at Lake Advisory Group, told The Balance by email.

As a result of the prime rate’s determination of the indexed rates used on ARMs, consumer interest owed on these mortgages can be affected drastically, depending on economic conditions.

If a benchmark such as the prime rate goes up, borrowers will see the interest on their mortgage increase proportionally. Simpson explained that this could result in higher payments due from one year to another. Usually, increases in benchmark rates are known well in advance.

“If you have a variable-rate or adjustable-rate mortgage, contact your lender, and even other lenders, about refinancing to lock in as low of an interest rate as possible now, before it gets more expensive to borrow money,” Simpson said.

Additionally, when rates are set to increase, Simpson said borrowers should focus on paying down any other outstanding debts before the cost of paying them off rises.

When it comes to borrowers looking to take out an ARM, a fully indexed rate comes into play. Lenders will calculate the variable interest rate using an index rate and a margin. While lenders don’t control the index rate, they do determine the margin, based on the borrower’s level of creditworthiness.

Several factors dictate the margin, but borrowers with the best credit scores and debt-to-income ratios (DTI) typically qualify for the lowest margins and receive lower-cost variable-rate loan offers compared with offers for fixed-rate loans.

While indexed rates fluctuate over time due to market conditions, margins are locked in and will not change throughout the life of the loan.

As mentioned, the fully indexed rate is equal to the margin plus the index. Lenders add a few percentage points to the margin to set the interest rate on an ARM. The margin depends on each lender and loan, but it usually doesn’t change once established. For example, if a lender uses an index that currently is 5% and adds a 4% margin, the fully indexed rate would be 9%:

5% + 4% = 9%

(Index + Margin = Fully indexed rate)

If the index on this loan rose to 6%, the fully indexed rate would be 10% (6% + 4%). If the index fell to 2%, the fully indexed rate would be 6% (2% + 4%).

Types of Index Benchmarks

Lenders decide which index benchmark they will use for their variable-rate products. The prime rate, U.S. Treasury securities, and Libor are the most common types.

Prime Rate

The U.S. market prime rate is the average interest rate at which banks lend money to other banks or pay when they borrow money from reserve banks and government treasuries. Banks also use the rate to lend money to their most creditworthy borrowers. In addition, many banks establish their own prime rate.

Note

The Wall Street Journal publishes the most up-to-date prime rate.

U.S. Treasury Bills and Notes

U.S. Treasury yields on bills and notes are used to benchmark interest rates on corporate bonds and mortgages. In addition, investors use U.S. Treasury securities as a benchmark to price other financial securities and investments, and as a basis for future market contracts.

Libor

Libor is the London interbank offered rate, which is the rate at which banks in London will lend to other banks. It’s traditionally been one of the most popular adjustable-rate benchmarks. However, by June 2023, all Libor-linked consumer loans will be phased out because the rate is based on transactions among banks that don’t occur as often as they did in prior years, making the index less reliable and credible. Borrowers with ARMs, reverse mortgages, student loans, HELOCs, or credit cards likely will see changes in how their interest rates are calculated when Libor is replaced.

Key Takeaways

  • An indexed rate is an interest rate tied to a benchmark that moves up or down with market conditions.
  • Indexed rates are used in variable-interest-rate products such as adjustable-rate mortgages, HELOCs, student loans, and auto loans.
  • Popular benchmarks for indexed rates include the prime rate, Libor, and U.S. Treasury bills and notes.
  • A fully indexed rate includes an index and a margin based on the borrower’s level of creditworthiness.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Consumer Financial Protection Bureau. “You Might Have Heard That LIBOR Is Going Away. Here’s What You Need To Know About LIBOR and Adjustable-Rate Loans.”

  2. Concordia University Irvine. “Fixed vs. Variable Interest Rates," Page 2.

  3. U.S. Federal Reserve Board. “Consumer Handbook on Adjustable-Rate Mortgages,” Page 7.

  4. Bank of America. “Prime Rate Information.”

  5. The Wall Street Journal. “Money Rates.”

  6. Brookings Institution. “What Does the Federal Reserve Mean When It Talks About Tapering?

  7. Consumer Financial Protection Bureau. “The LIBOR Index for Adjustable-Rate Loans Is Being Discontinued: Here’s What To Watch For.”

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