An index rate is the standard that lenders use to determine the amount of interest a borrower will pay on a variable rate loan. Generally, credit cards, home equity loans, personal loans, and auto loans are variable rate loans. Unlike a fixed loan, which uses a set interest rate for the life of the loan, the interest rate on a variable rate loan fluctuates periodically. In other words, the interest rate on the loan changes, usually every three, six, or twelve months, based on a specified index rate.
Typically based on a particular money market rate or the average interest rate in a particular trading market, different index rates are used for each type of loan. In the United States, for example, the prime rate is the most common factor used to determine interest rates for variable rate loans. Reported daily by the Wall Street Journal, the prime rate is based on the borrowing costs of banks in the global market, as well as the rate of return offered on certificates of deposit, savings accounts, and money market accounts. The interest rate for an adjustable rate mortgage, on the other hand, is usually determined by the Cost of Funds Index rate (COFI). This is the average amount of interest paid by banks and other financial institutions in a particular region.
Other commonly used index rates include the London Interbank Offered Rate (LIBOR), the Constant Maturity Treasury (CMT), and the Cost of Savings Index (COSI). Updated daily, the LIBOR is based on the interest rate that banks are charged to borrow unsecured funds in the London wholesale money market, while the CMT depends on the weekly or monthly average of a country’s treasury securities. The COSI uses the average interest rate that a particular bank’s depositors pay on their certificates of deposit. All index rates are published regularly and can be easily found by consumers, once they know which index rate their loan uses.
Although the index rate greatly influences the interest rate of a loan, the final rate is determined by adding the amount charged by the bank, or margin, to the index rate. For example, if the index rate is 5% and the bank’s margin is 2%, the final interest rate would be 7%. Typically, borrowers can expect to receive a 2% to 4% margin rate, however, the exact amount varies based on the bank and the applicant’s credit history.
