Interest rates: what they are and what effects they have

You may have heard about interest rates, especially during the last couple of years, since the pandemic started to hit the World. Read more!

You may have heard about interest rates, especially during the last couple of years, since the pandemic started to hit the World. Interest rates usually drive the financial world, but who set them and how they affect the markets? Let’s have a look!

Interest rate is the remuneration that a lender receives and the cost that a debtor incurs. A simple concept, which however often escapes by chasing acronyms and index technicalities. Here are the most important ones, to better orient yourself between mortgages and economic policy.

The interest rate of the European Central Bank

The ECB rate is the general indicator of the entire Eurozone system and that’s why it is called the “reference rate”. Once, when the rates were national and the central banks of each economy decided them, it was called the official discount rate but the substance does not change: ECB rates are the main parameter for defining the main refinancing operations.

In other words, they determine the cost of money which, passing through the banks, affects the credit granted to households and businesses. The ECB therefore has the role of regulator: if the economy slows down, low rates stimulate investment, consumption and – in general – greater circulation of liquidity; if the economy accelerates, rates are adjusted upwards to prevent excessive inflation.

Obviously, we’ve just taken ECB rates as an example, but the same can be said about Federal Reserve, Bank of England, Bank of Japan’s rates etc…

EURIBOR

EURIBOR stands for Euro Inter Bank Offered Rate. As the name implies, it is the average interest rate of transactions between European banks. In fact, banking institutions do not only lend money to families and businesses but also exchange liquidity among themselves.

Banks that have it in abundance make short-term loans to those that are short of it. The EURIBOR, therefore, influences the cost of money borne by the institutions, and represents the reference point for variable rate mortgages, to which the bank adds a more or less high spread.

EONIA

The EONIA is the Euro OverNight Index Average. In practice, it is the overnight EURIBOR: the average interest rate at which banks grant and request loans for a period of one day. That is, in the space of one night (overnight, in fact).

LIBOR

LIBOR, or the London Interbank Offered Rate, is the UK equivalent of EURIBOR. It is therefore the reference rate at which institutions exchange money on the London interbank market. It is a floating rate, calculated and published every morning by the British Banker’s Association.

However, its impact does not end in the City: if the EURIBOR is the reference rate for transactions in euros. LIBOR usually performs the same function for exchanges in other currencies.

SONIA

From 1 January 2022, Libor switched to a system based on a set of risk-free overnight rates with the acronym RFR. They are based on transactions that took place the previous day. The new rates is therefore decided on the basis of contracts already closed. Not on estimates as was the case in the past.

What will they be? The Libor in British pounds will be replaced by SONIA: an acronym for Sterling Overnight Index Average; the one in euros will be replaced by the € STR (Euro Short-Term Rate); while the SOFR, Secured Overnight Financing Rate, will come in place of the libor in dollars. Substitutes for the Libor have also been found for other currencies, such as: the Australian dollar; the Japanese yen and the Swiss franc.

IRS (EURIRS)

If those who have taken out a variable rate mortgage must look mainly at the EURIBOR, those who have chosen the fixed rate will have to refer to the IRS (Interest Rate Swap), also called EURIRS. It is the average rate at which the main European banks enter into swaps to hedge the risk. It represents the basis (to which a spread will always be added) for calculating interest on mortgages.

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