Interest Rates 101

Index Rates

The interest rates on private consolidation loans are based on market indexes (tied to the lenders' cost of funds) + a credit spread which compensates the lender for the risk of default in lending to consumers. The market index is variable, but the credit spread is fixed based on your credit. Private loan rates are typically indexed to either LIBOR or the Prime Rate.

What is LIBOR?

This is the rate of interest at which banks borrow funds, in marketable size, from other banks in the London Interbank market. In other words, LIBOR is the international rate that banks borrow from other banks. It is the most widely used benchmark or reference rate for short term interest rates.

What is the Prime Rate?

This is the interest rate that commercial banks charge their most credit-worthy customers. Generally a bank's best customers consist of large corporations. Default risk is the main determiner of the interest rate a bank will charge a borrower. Because a bank's best customers have little chance of defaulting, the bank can charge them a rate that is lower than the rate that would be charged to a customer who has a higher likelihood of defaulting on a loan.

Private Loan Rate Calculation Example

3M LIBOR + Credit Spread = Total Rate
4.50% + 3.50% = 7.75%

Rate Resets

Rates on private loans typically reset quarterly and monthly payment amounts adjust accordingly. The credit spread remains constant and the change in total rate is simply a function of the underlying change in the short-term LIBOR rate.