The reference rate is that set by an official entity and that serves as the basis for calculating the interest rate that will be paid for a financial transaction. This, usually adding a spread called a spread.
In other words, the reference type functions as a "floor" or "floor" to which an additional percentage is added. In this way, the interest rate on a loan is determined.
Some known interest rates are:
- Euribor: It is the interest rate at which eurozone banks lend money to each other. The European Money Markets Institute (EMMI) calculates it daily.
- Libor: It is the rate based on interest rates at which British banks lend money to each other in the interbank market. It is published daily by the British Bankers Association.
- Preferential interest rate or prime rate: It is the interest rate that US banks charge to their best clients, that is, to those who have a lower risk of defaulting.
Reference rate and monetary policy
Central banks set a reference rate from which they manage monetary policy. This, because said indicator serves as the basis for interbank loans.
To understand the above, we must take into account that the monetary authorities require a minimum reserve requirement (reserve that cannot be used) from banks. Thus, those financial entities that do not meet said requirement can request short-term loans from other surplus institutions.
Thus, the cost of these credits between financial institutions is known as the interbank interest rate. This will vary in the same direction as the reference rate (if one goes up or down, the other goes too).
So, the reference rate works as a monetary policy tool because, when it rises, the interbank interest rate also increases, increasing the cost of banks to obtain funds. Therefore, interest rates for the public will rise and lending will stop.
On the contrary, if the reference rate is lowered, the cost of financing will also decrease. In this way, for example, the economy could be given a boost in the face of a recession.
Reference type example
Suppose that the bank grants a mortgage loan with a variable interest rate where the reference rate is Euribor plus a spread of 5%.
So, if the Euribor is at -0.28%, the applicable interest rate for the loan will be 4.72%.
It should be noted that, as it is a variable interest rate financing, each payment period (for example, each month) will be updated with an interest rate.
Advantages and disadvantages of the referral rate
The reference rate is an advantage for the lender taking into account that a minimum income is ensured. However, the interest rate could vary greatly over time. Consequently, the creditor's income could also be somewhat unstable.
On the other hand, from the point of view of the debtor, the advantage of the reference rate is perhaps that it helps them understand how the cost of financing is calculated.
However, if the reference rate goes too high, this could affect the borrower's finances.