A reference interest rate determines the changes in variable-interest contract transactions. Such financial products mainly include savings, but also some loans. It is important that the reference interest rate cannot be influenced by either of the contracting parties, but is specified by a neutral body. If the reference interest rate changes, the interest rate on the savings or loan also changes.
- Savers benefit from a rising reference interest rate because the bank credits them with more interest on their savings, while borrowers benefit from a falling interest rate because they have to repay their loan with less interest.
- Anyone who invests their money in the derivatives market should also know what reference interest rates are, because they often have an impact on the financial instruments traded there.
What reference interest rates are there?
For European banks, investors and borrowers, the EURIBOR (Euro Interbank Offered Rate) is the most important reference interest rate. It is calculated every day by a specialized service provider for different running times. It is based on the interest rate offers of selected European banks, which announce the interest rates at which they lend money to other banks. The EONIA (Euro Overnight Index Average) is decisive for overnight bonds in the euro zone.
Another important reference interest rate is the LIBOR (London Interbank Offered Rate), which is also calculated for currencies other than the euro, but not for all. The CHF-LIBOR, the NIBOR, the HIBOR, the SHIBOR and the TIBOR, for example, also work according to his model.
The key interest rate of the European Central Bank (ECB) is also a reference interest rate in the broadest sense. It indicates the interest rate at which European banks can borrow money from the ECB. This of course also determines the level of the interest rates that banks charge each other for loans, and thus also the EURIBOR.
Reference interest rate and savings
In the case of savings investments , for example a call money account , changes in the reference interest rate also affect the interest rate of the investment product. For example, if the reference value increases by 0.5 percentage points, the interest rate on the overnight money account also increases. Using the example of EURIBOR, however, one can also see a different influence of a reference interest rate on savings investments.
If the EURIBOR is very high, the banks have to pay a lot of interest when they borrow money themselves. That is why they prefer to raise new money by attracting as many savers as possible for a longer period of time. They offer them high interest rates that are still below those of the EURIBOR for the same period. The banks then have the money of the savings investors at their disposal and can lend it to other banks at an interest rate linked to the EURIBOR. This is how they make a profit because the difference between the interest rate on savings and the EURIBOR remains with them.
Reference rate and loans
According to digopaul, reference interest rates also play an important role in the cost of loans. If a bank wants to borrow money from another bank, it will always use the EURIBOR interest rate. In this way, she can assess whether another credit institution is offering a loan at a low or a high interest rate.
Loans with a variable interest rate, which in turn is based on a neutral reference value, are not very common, but are quite possible. In this case, coordination with the reference interest rate takes place after a certain period of time, often quarterly. In most cases, “cap” and “floor” are also agreed for such loans. The cap denotes the highest possible interest rate that may be charged, and the floor the lowest. This ensures that a borrower does not go into debt through excessive interest rates and that a lender makes an acceptable profit.
What are the advantages of the reference interest rate?
A reference interest rate creates clarity and transparency for banks and consumers. It makes it easier for providers of financial products to find prices and makes price comparisons easier for everyone looking for cheap loans or profitable investment opportunities. From the development of the reference interest rate, interested parties can also deduce how the interest rate of a loan or a savings investment will change. If you keep an eye on the reference interest rates, you can therefore miss a good time when the conditions for loans or investments are particularly favorable.