What are benchmark rates?
Interest rates are a very relevant concept when we talk about investment. In addition to the rates associated with products such as checking accounts or investment funds, central banks set official interest rates. Moreover, there are other indicators, the benchmark rates, that help central banks do their job: defining monetary policy. In this article, we will explain what they are and how they work.
First of all, it’s essential to remember the basics of interest rates. They are nothing more than the price we pay to borrow money, or the money paid to us when we lend it. Most of us start learning about interest rates when we open a bank account – to know the return on a deposit, for example – or when we take out a loan – like a mortgage.
In this context, it’s crucial to understand what rates we are being told about. For instance, a mortgage may have an interest rate of 1.8%, but an annual percentage rate (APR) of 2%. The second figure is more important to keep in mind because it represents the total cost of the loan expressed as an annual percentage. That is, the APR takes into account the fees and charges associated with the loan or credit.
Another basic distinction is between the nominal interest rate (NIR) and the real interest rate. The NIR represents the percentage on the capital that must be paid over a specified period. It’s a useful indicator, but it doesn’t tell the whole story since it doesn’t account for inflation. This is why we also talk about real interest rates. Let’s look at an example: if an asset offers an annual NIR of 5% and inflation is 4%, then the real interest rate is only 1%. That would be the asset’s real return.
Official interest rates
Beyond all these considerations, there are other interest rates, the instruments central banks use to define the monetary policy of a country or a group of countries that share a currency, like the eurozone. In our closest example, the European Central Bank (ECB) sets official interest rates and, in doing so, establishes monetary policy in the 20 European Union countries that use the euro.
Central banks like the ECB are not ordinary banks. Rather, they are the rates that commercial banks use to finance themselves or deposit liquidity – the so-called banking reserves. This is where official interest rates come into play, as they set the conditions under which ordinary banks interact with the central bank and, by extension, influence how banks interact with each other and the rest of the economy.
Here, we refer to the interest rate on main refinancing operations – which determines the cost of financing for commercial banks over a week with the ECB – the deposit facility rate – the price the ECB pays for the deposits of commercial banks – and the marginal lending facility rate – the rate the ECB charges banks for overnight loans.
Benchmark rates
So, what are benchmark rates? These are reference indices used in all types of financial contracts, such as mortgage loans. If you have a variable-rate mortgage, you are probably very familiar with one of the main benchmark rates: the Euribor.
As explained by the Bank of Spain, “the most common benchmark rates are the so-called interbank market rates, such as the Euribor or the €STR (which recently replaced the EONIA), i.e., the interest rates at which banks and other financial intermediaries lend to each other. This information helps central banks understand the state of monetary policy transmission to the interbank market.”
The Euro Short-Term Rate (€STR)
The €STR (Euro Short-Term Rate) is a benchmark index that reflects the cost of money in euros over the short term in the interbank market. Introduced by the ECB in October 2019, the €STR is calculated based on unsecured loan transactions between banks. Its goal is to provide a more accurate and representative reference for short-term interest rates than its predecessor, the EONIA (Euro Overnight Index Average), which was discontinued in 2022.
The €STR is used as a base for various financial products – such as loans, mortgages, and derivatives – and thus affects businesses, financial institutions, and investors. Moreover, it is considered a key benchmark for determining the cost of borrowing in euros, which directly influences the financial planning of many economic actors.
For investors, the €STR is a crucial indicator, as it reflects liquidity conditions and risk in the eurozone. It is also relevant for real estate investment, as changes in this index can affect financing costs for developers and buyers, as well as the profitability of products related to debt or real estate loans.
Euribor
The Euribor (Euro Interbank Offered Rate) is the average interest rate at which major banks in the eurozone lend money to each other over the short term. It is calculated daily based on quotes provided by a panel of top-tier banks and serves as a key reference index for loans, mortgages, and financial products.
Introduced in 1999, the Euribor is a fundamental reference in the mortgage market of the eurozone, as many variable-rate mortgages are linked to this index. When the Euribor rises, mortgage payments usually increase, and when it falls, they tend to decrease, making it a crucial indicator for consumers and the real estate sector.
In the realm of real estate investment, the Euribor influences the cost of financing for developers and buyers. It also directly impacts the profitability of certain financial products tied to the real estate sector, such as loans or bonds. For investors, monitoring the Euribor is essential, as it reflects liquidity conditions and the level of confidence among banks in the eurozone, which can foreshadow changes in the cost of credit and the overall economic environment.
In summary, reference interest rates, such as the Euribor and €STR, are key indicators that reflect the economic and financial conditions in the eurozone. They are essential for consumers, businesses, and investors alike, as they directly influence the cost of loans and the profitability of financial products. Understanding how they work is useful for making informed investment decisions.