1. What are the components of an interest rate?
An interest rate consists of a benchmark rate plus a margin (spread) added by the bank to cover its costs and risk.
2. What are the main benchmark rates?
The Euribor, IRS, and Prime Rate are the primary benchmark rates. To understand the distinction, one must first recall the difference between variable-rate and fixed-rate loans.
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Variable-rate loans: These rely on short-term rates that fluctuate throughout the term of the loan. The borrower therefore assumes the risk of rising interest rates. Variable-rate loans are generally indexed to the Euribor (Euro Interbank Offered Rate), which is quoted for various maturities (e.g., 1-month, 3-month, 6-month, or 1-year Euribor). At the end of each period, the rate is adjusted up or down and applies to the next period.
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Fixed-rate loans: The interest rate is locked in for the entire term of the loan, protecting the borrower from any interest rate risk. A common benchmark rate in this case is the Prime Rate, which represents the average of the best rates offered by commercial banks to their corporate clients. The Prime Rate is quoted across ten different maturities (from 1 to 10 years) and already includes a small margin for the bank. Another benchmark for fixed-rate loans is the IRS (Interest Rate Swap) rate. This rate is set by the market when hedging against interest rate risk by exchanging (swapping) floating-rate cash flows for fixed-rate ones. The IRS rate reflects market expectations regarding the future trajectory of short-term rates. Plotting IRS rates across maturities yields the yield curve.
3. How do interest rates move?
The European Central Bank (ECB) sets its key policy rate, which serves as one of the primary funding sources for commercial banks. As a result, the ECB directly influences short-term interest rates (such as the Euribor). Long-term rates, on the other hand, are not set by central authorities; rather, they reflect market expectations. If economic prospects are bright, long-term rates rise (resulting in a steep yield curve); if expectations are gloomy, long-term rates fall (leading to a flat or inverted yield curve).
4. How much is the bank's margin?
The margin depends on the level of risk. Banks today rely on sophisticated scoring systems to measure the credit risk of each transaction. This assessment incorporates several variables: the borrower's creditworthiness (expressed via a rating or risk class), the loan maturity, and collateral provided. It is worth noting that, since the banking crisis, commercial margins also incorporate a liquidity premium to account for higher funding costs in the interbank market.
5. What is a "funding loss"?
When a borrower decides to prepay a loan before its maturity, the bank often levies a penalty known as a "funding loss" (indemnity fee). This compensates the bank for the loss incurred when redeploying the prepaid funds in an environment where interest rates have dropped. The funding loss is calculated as the spread between the current market rate and the contractual rate over the remaining term of the loan. Consequently, no funding loss applies to variable-rate loans or when interest rates have risen since the loan was originated.
6. Nominal, real, or effective interest rate?
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Nominal rate: The contractual rate agreed upon at the outset and stated in the loan agreement.
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Real rate: Adjusts the nominal rate for inflation and risk premiums. While harder to compute, it allows for a truer comparison of real returns across different transactions.
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Effective rate: Recalculates the nominal rate on an annualized basis, accounting for payment frequencies and compounding intervals. For consumer loans, displaying the Annual Percentage Rate (APR / TAEG) is a legal requirement.
An informed borrower is well-positioned to negotiate interest rate terms with their bank, ensuring they pay a fair price for a essential service: obtaining the capital required to execute their project.
Illustration: Clou
