A loan or other financial transaction that includes a variable, or floating, interest rate generally specifies a reference rate, known as a benchmark. Reference rates are used to calculate the interest rate and payment due on a loan. Common reference rates include the London Interbank Offered Rate (LIBOR) and the Prime Rate in the United States.
Generally, variable interest rates are updated at set intervals, such as monthly or annually. The LIBOR reference rate is commonly used in adjustable rate mortgage (ARM) loans. ARMs have a fixed rate for certain number of years. After the fixed interval, the interest rate is usually updated each year, based on the reference rate listed in the contract.
For example, a 5/1 ARM will have a fixed interest rate for the first five years. The '1' indicates that the rate will be adjusted at the end of year 5, and every year after that. The typical contract states that the adjustable rate will equal LIBOR, plus 3%. In year six, and all subsequent years, the interest rate will be adjusted up or down, based on the current LIBOR rate. The borrower will pay this new interest rate for one year, until the rate is adjusted again.
While LIBOR is a popular choice for an ARM reference rate, other rates can be used as well. Any published rate such as the Consumer Price Index or unemployment rate can be used a reference rate. The Prime Rate is commonly used in the United States as a reference rate for credit card interest rates.
Both the lender and borrower should choose reference rates that neither can influence nor control. This will help avoid a conflict of interest. Parties that use contracts with reference rates are also protected from interest rate risk. The borrower pays the going rate for a loan, while the lender continues to make a profit on the spread listed in the loan agreement.
To help ensure a fair rate for the borrower, variable-rate loan agreements generally include an annual and lifetime interest rate caps. These caps put limits on the interest rate regardless of the change in the reference rate. There are challenges with using a reference rate, however. The borrower will not know what the loan interest rate and payments will be from year to year. Also, even with interest rate caps in place, if interest rates spike, loan payments can balloon to a level that the borrower cannot afford.
Alternatively, both lenders and borrowers can opt for fixed-rate loan agreements instead of variable contracts that use reference rates. Fixed-rate loans include one interest rate for the life of the loan. Generally, the interest rate will remain the same, unless the lender makes late payments or defaults on the loan.