What Is an Interest Rate Index?

M. McGee
M. McGee
Man climbing a rope
Man climbing a rope

An interest rate index is a specific known rate that is used to establish other interest rates. There are several common interest rate indexes used by various organizations for various reasons. In nearly every case, these rates are used as a base for the rate given by a lending or credit company. These companies take the rate and add a specific amount to it, generally called a margin, to come up with the final interest rate passed on to a customer. This is the method used to determine variable interest rates for credit cards, mortgages or loans.

Most developed countries have a common interest rate index used by the majority of their lenders. These indexes are usually tied to a large bank or corporation, a value established by the government or an aggregate of a number of different companies, banks and government groups. Smaller countries, often those with weaker economic influence, will use an interest rate index from another country, or a single entity will establish a rate for a large region. For example, much of Western Europe uses Euro Interbank Offered rate as an index.

These indexes are of vital importance to consumers, as they establish the values used in adjustable- and variable-rate loans and credit. Creditors will take the published rate from their interest rate index of choice and apply a fixed amount to determine the final interest rate used by consumers. As the index rate rises and falls, the associated variable rates do as well. This can mean a huge savings or loss for the consumer based on the size of the original loan.

The value given by the interest rate index is an indicator of the supply and demand on loans at the time. As the rate falls, the supply of money available for loans is high. The lower interest rate entices people to borrow money and equalize the market. When interest rates are high, then the available money for loans is low. The higher rate discourages people from asking for money until the market moves back to the middle.

These indexes are used for variable-rate systems, but not fixed. When a lender offers a fixed rate for a loan or credit, then that value doesn’t change unless the credit agreement expires or is broken. This can be good or bad for the end consumer depending on the overall market. If the debtor has a low fixed rate and the index goes up, then he will be saving money over a variable rate. If the index drops below the fixed rate, then he is paying more.

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