Quick Look
- A benchmark interest rate is an interest rate that determines the amount of other interest rates.
- Two important benchmarks are the federal funds rate set by the Federal Reserve and the prime rate set by banks.
- Higher benchmark rates mean a higher cost of borrowing money.
If at any point in the last six months talk of the Federal Reserve changing interest rates has blown up your media, you’re not alone. You’re also probably not alone if you’ve always wondered what on earth they were talking about but were too afraid to admit you didn’t already know.
They were referring to a type of benchmark interest rate that influences a lot about financial life in the United States. If you have credit cards or plan to borrow money, it affects your financial life too.
That’s why it’s crucial you understand what benchmark interest rates are and how they work.
What Are Benchmark Interest Rates?
At its most basic, a benchmark interest rate is an interest rate that determines the amount of other interest rates. For example, when you get a mortgage, the interest rate you pay is the benchmark rate, also called a reference rate, plus a certain percentage.
That’s easy enough to understand. But as with many things in the world of finance, it gets more complicated in its execution. First, there are many different benchmark interest rates. And they’re not all created equal.
Common Benchmark Interest Rates
The most talked-about benchmark interest rates in the United States are probably the federal funds rate and the prime rate. Libor and SOFR, its successor, also make an occasional appearance.
There are many different benchmark interest rates globally, but understanding the primary American benchmarks goes a long way to understanding how they work in general.
The Federal Funds Rate
The federal funds rate, also called the federal interest rate, is a rate set by the Federal Reserve. The committee that sets it bases it on economic indicators like inflation. It’s usually a short range, such as 3.70% to 4%.
The federal funds rate influences how much real money banks must keep in their reserve accounts by law, which is a certain percentage of their deposit accounts. They can borrow and lend among themselves to ensure they all have the required resources in those accounts.
The Prime Rate
The prime rate is the rate banks charge their best customers. And by “best,” I mean creditworthy. And by “customers,” I mean not you. Don’t feel bad. It’s generally the rate they give big corporations.
Each bank establishes its own prime rate. It’s usually based on the federal funds rate. That’s right: It’s a benchmark rate that uses another benchmark rate to set its benchmark.
The prime rate can be whatever the bank wants, but most banks use a similar guideline to set it, the federal rate plus 3%, give or take. Some even just use the prime rate The Wall Street Journal publishes.
If they wanted to, they could just roll dice. Importantly, there’s no requirement banks change their rates along with the Fed or even use that rate to begin with. They just use what works, and the federal funds rate or WSJ method keeps them competitive and in the black.
Banks then use the prime rate to set the rest of their rates — i.e., the rates they give you — which will be higher based on how your creditworthiness compares to prime customers’ creditworthiness.
Honorable Mention: Libor & SOFR
Oh, poor, sweet Libor. The “London Interbank Offered Rate,” as it is otherwise known, has been plagued by scandal. As its non-initialized name suggests, Libor (pronounced LIE-bor) is a global benchmark rate analyzing the rates among the top world banks to set its benchmark. As a benchmark, it’s an alternative to the prime rate, usually for larger loans, such as those taken out by businesses. It’s based on reporting banks’ quotes for how much they’d pay to borrow money.
Lest you think that has nothing to do with you, there’s more.
Historically, it has influenced everything from the rates banks charge each other to the cost of financial instruments like savings accounts and mortgages. Then, in the early 2010s, it came out that Barclay’s (and likely other banks) were manipulating the numbers to make the picture appear rosier than it was.
That may actually explain the role LIBOR played in the Great Recession. The powers that be used what we now know to be a lower-than-realistic Libor to set the rates on investments used to insure subprime mortgages against default — oops.
Knowing that, it should come as no shock many U.S. banks that use Libor are transitioning to SOFR, the Secured Overnight Financing Rate. It’s based on what U.S. banks charge each other for Treasury bond repurchase agreements. It’s insulated from the type of manipulation Libor experienced because it’s based on actual financial transactions rather than (potentially make-believe) estimates.
How Benchmark Interest Rates Work
And now the part you’ve been waiting for — how all this financial hullabaloo affects you. The rates you pay on everything from personal loans to credit cards are based on a benchmark rate.
No matter what that benchmark rate is, you pay that plus a specific percentage. For example, the bank may offer you prime plus 2%. If the prime rate is 6% today, that means you pay 8%. But if you wait until next week to take them up on the offer and the prime rate goes up to 6.25%, you must pay 8.25%.
While you have no control over the benchmark rate, the amount you pay in addition to that is based on your creditworthiness and the way you borrow the money.
Your creditworthiness is the level of risk you present as a borrower based on things like your credit history, amount of debt, and income. The higher the risk to the lender, the higher the interest.
For example, a bank may advertise a particular loan product for prime plus 1%. But generally, only the borrowers with the best credit (whom you may have heard referred to as “well-qualified”) necessarily get that rate. Everyone else’s interest rate is higher. How much depends on their creditworthiness.
Lenders also charge interest differently based on how you borrow the money.
- Variable-Rate Loans. These generally have the lowest markup — prime plus 1 to a few percentage points. The bank can and will increase what you pay if prevailing interest rates (the rates most banks charge) go up, so they don’t stand to lose anything if circumstances change. Sure, you pay less interest if rates go down. But so do they on the money they borrow, so it’s a win-win.
- Fixed-Rate Loans. These present a bit more risk for lenders in the sense that they can’t increase the rate unless you refinance. So if there’s unexpected market turmoil and the Fed increases the funds rate, they’re stuck with your lower-interest loan while they pay higher interest on their loans. But you also don’t have to worry about that, so they charge you a bit extra for that peace of mind in the form of a higher rate.
- Credit Cards. Revolving credit is a different beast. They check your creditworthiness when you apply and put limits on it based on that, but once you pay back whatever you borrowed, you can borrow it again, even if your circumstances have changed for the worse. Plus, it costs a lot of money to maintain 24-hour real-time credit card processing. As such, you pay a premium for this credit type in the form of double-digit interest on the low end.
- HELOC. A home equity line of credit is also revolving credit, but since your home acts as collateral (something they can take if you don’t pay), the rates are much lower than on credit cards. That’s because there’s very little risk to the bank unless you default just when the housing market crashes and it forecloses on a home that’s suddenly worth less than you owe.
Benchmark Interest Rates in Action
Let’s say you have a credit card. Through a series of odd circumstances and the magic of the Example-verse, you always carry a $3,000 per month balance.
Your interest rate is currently 16% (go, you!). In the Example-verse, that’s because the prime rate is 6% and the credit card gives you prime plus 10%. For the sake of argument, let’s say the bank’s prime rate is always exactly 3% above the lowest number in the federal funds rate range, though in the real world, that’s not how it works.
Now, let’s move forward in time. (You just pictured everything speeding up like in the movies, didn’t you?). Let’s see what happens as the Fed increases the federal funds rate, which influences the prime rate.
As you can see, even movements as small as a couple of percentage points can have a profound impact on how much interest you pay. If interest rates had stayed at the January rate, you’d have paid only $5,760. That’s a $300 difference. Now imagine the difference on a $300,000 adjustable-rate mortgage.
Do You Need to Pay Attention to Benchmark Interest Rates?
If you have a loan or credit, knowing what’s happening with the benchmark rates can help you understand what’s going on with your accounts. And if rates start trending a little rich for your blood, it might give you a heads up about the need to prioritize or refinance certain debts.
If you’re planning to borrow soon, following benchmark rates, especially the actions of the Federal Reserve and the fed funds rate, can clue you in about when it might be a good time to borrow. That way, you don’t miss out on the lowest rate possible.
Benchmark Interest Rates FAQs
Benchmark interest rates affect every dime you borrow. So it’s understandable if you have questions.
How Often Do Benchmark Interest Rates Change?
There’s no set schedule for benchmark interest rate changes. The Federal Reserve is responsible for ensuring the economic health of the nation. And they change the federal funds rate when economic conditions dictate they should (not that it’s as easy as all that).
And since the prime rate is tied to that, banks typically change the prime rate around the same time, though there may be a one- or two-month lag.
Overall, you can expect the rates to change several times per year.
Do Benchmark Rates Affect My Savings Account?
Not directly. But if there were a silver lining to higher benchmark interest rates, you’d find it in your high-yield savings account.
There’s no direct correlation between the federal funds or prime rate and savings rates, but banks may increase savings rates over time as the market moves.
Are There Other Types of Benchmark Rates?
Yes. In finance, there are lots of types of benchmarks used to measure things. For example, accountants use benchmarks to ascertain how much companies are worth, and economists use them to measure the health of the economy.
Another type of financial benchmark you hear about all the time is the Dow Jones Industrial Average. That’s one investors use to measure the risk or reward on investments.
They all work similarly in that they act as a form of measuring stick. But they use different data and may tell you about different facets of finance.
Which Benchmark Rate Is the Best?
There’s no one perfect benchmark interest rate. They all attempt to measure similar things with different data points. In fact, there’s nothing inherently wrong with Libor. It was human manipulation that caused issues with that measurement, not the data itself.
Ultimately, the most important benchmark to you is that one that affects your life. And for most Americans, that’s the federal funds rate (indirectly) and the prime rate (directly). If you have investments, it could be an investment-related benchmark like the Dow Jones Industrial Average.
Final Word
Benchmark interest rates, especially the federal funds rate, are one of those things the TV talking heads love to blather on about. And a lot of viewers probably think that’s something that’s only important to people who wear expensive suits to jobs they have to walk past a giant bronze bull to get to.
But if you borrow money or have any kind of variable-interest debt, pay attention when they talk. It could affect the size of the automatic payments that come out of your bank account each month.
