Variable rates: how index plus spread works

Your rate is two numbers added together, and each one moves for different reasons.

A variable rate is almost never quoted as a single number in the agreement. It is quoted as an index plus a spread. Knowing which part is which tells you what your rate will do and who controls it.

The index is a published market reference rate. It moves with short-term rates in the economy and is not set by your lender. The spread is the lender's margin over that index, expressed in basis points, where one hundred basis points equals one percent. The spread is set by the lender, usually tiered by loan size, and it is the part that reflects you.

rate = index + spread

index: A published short-term reference rate. Moves with the market; your lender does not set it.
spread: The lender's margin, in basis points. Set by the lender and typically tiered by balance.
rate: What you actually accrue at. Recomputed whenever either component changes.

Two features surprise people. First, the reset frequency: some facilities reset with the index daily or monthly rather than on an anniversary, so the rate can change several times inside one statement period. Second, the spread is not necessarily fixed for the life of the loan either; many agreements permit revision. So a rate can rise because the market moved, because the lender re-tiered you, or both — and a statement that shows only the resulting rate does not tell you which.

The tiering has one non-obvious effect. If the spread falls at higher balances, a partial repayment can move you into a worse tier, raising the rate on what remains. The total interest can therefore move less than the repayment implies.

Key terms

Index (reference rate): A published market rate your loan is priced against. Set by market conditions, not by your lender.
Spread: The lender's margin above the index, quoted in basis points. 100 basis points = 1.00%.
Reset: The moment your rate is recomputed from current index plus current spread.

Worked example

Decomposing a rate change

A line quoted at index plus 175 basis points. Index starts at 4.60%.

Starting rate: 6.35%
Index rises to 5.10%: Rate 6.85%
Spread re-tiered to 225 bps: Rate 7.35%
Statement shows: 6.35% → 7.35%
Attribution: 50 bps market, 50 bps lender

One point of rate increase, two entirely different causes, and only the sum is printed. Separating them requires the index history and the agreement.

Check yourself

Your rate goes from 6.35% to 7.35%. What two things could have caused it, and can you tell which from the rate alone?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.