A benchmark interest rate is a commonly agreed standard by which other interest rates will be calculated. Think of it as a price standard that can be added to and subtracted from, to account for other factors.
Function
The aim of a benchmark interest rate is to give a base price, an agreed standard, from which other interest rates can be calculated. Interest rates are often quoted as the appropriate benchmark, plus some percentage.
Federal funds rate
The federal funds rate is a benchmark interest rate. It is the rate at which American banks lend to each other in dollars. Many other interest rates are calculated from it; the federal fund rate plus 0.25 percent, for example, would be the interest rate on a loan to a large company.
LIBOR
LIBOR (London InterBank Offer Rate) is similar to the federal funds rate as a benchmark interest rate. It is the rate at which banks in London will lend to each other. Many corporate loans are priced at LIBOR, plus or minus some percentage.
Misconceptions
It is a misconception that there is only one benchmark interest rate. LIBOR, for example, comes in 10 currencies—U.S. dollars, euros, pounds and so on—and a number of maturities—one-day, seven-day, 30-day and so on, up to 10 years. Imagine a company wanting to borrow U.S. dollars for one year. The lender would take the U.S. dollar one-year LIBOR as the benchmark interest rate, then add a percentage based on what's appropriate for the risk of the loan.
Floating-rate loans
The most common use of a benchmark interest rate is to price floating-rate loans. A floating-rate mortgage, for example, could be based on the federal funds rate or LIBOR. The loan contract would state that the interest rate would have a 2 percent margin, or 200 basis points, above the benchmark rate. As the benchmark rate changes over time, so would the total interest rate of the mortgage, but it would always be 2 percent above the changing benchmark rate.
