Reset Rate: What it is, How it Works, Example

What Is a Reset Rate?

A reset rate is the new interest rate that a borrower must pay on the principal of a variable interest rate loan when a scheduled reset date occurs. The lender will provide details on a loan’s reset terms and interest rate calculations in the borrower’s credit agreement.

How a Reset Rate Works

A reset rate can be associated with all types of variable interest rate loans. A variable rate loan is a loan with an interest rate that fluctuates over time because it is based on an underlying benchmark interest rate or index that changes periodically.

While most variable rate personal loans have a floating rate that changes whenever the underlying indexed rate increases or decreases, there are some types of variable rate loans that are structured with a specified interest rate resetting schedule. A lender can structure any type of variable rate loan with interest that resets on a specified schedule. For example, adjustable-rate mortgage loans have a specified interest rate resetting schedule.

Variable interest rate loans are a complex product; they include both an indexed rate and a margin in the interest rate calculation. Lenders base the loan on a specified indexed rate, usually the prime lending rate, the London Interbank Offered Rate (LIBOR), or a U.S. Treasury rate.

In the underwriting process, a lender will assign a margin to borrowers seeking a variable interest rate credit product. The margin is based on a borrower’s credit profile; for low credit quality borrowers, the margin will be higher. For high credit quality borrowers, It will be lower. The borrower is responsible for paying the fully indexed rate, which includes the indexed rate plus the margin.

In most variable interest rate loans, the fully indexed rate will change whenever the underlying indexed rate increases or decreases. In a variable interest rate loan with scheduled reset dates, the rate will be reset based on the schedule detailed in the loan terms. Variable interest rate loans can be reset on various schedules, which may include monthly, quarterly, or annual reset dates. If a loan has a scheduled reset date, then the reset rate will be changed to the fully indexed rate on that date. A rate can increase or decrease based on the market rate. It may also remain the same.

One obvious advantage of a variable interest rate is that if the underlying interest rate or index declines, the borrower’s interest payments also fall. Conversely, if the underlying index rises, interest payments increase. 

Example of a Reset Rate

Adjustable rate mortgage loans are one of the most common lending products using a scheduled reset date. These loans offer borrowers both fixed rate and variable rate interests over the life of the loan.

Borrowers can usually identify an adjustable rate mortgage loan with a scheduled reset date by its name. For example, a "5/1 ARM" loan would pay a fixed rate of interest for five years, followed by a variable rate that resets each year. The borrower’s first reset date would occur at the end of the fifth year. At this time, the interest would be reset to the borrower’s fully indexed rate. The fully indexed rate would then be reset on a 12-month schedule for the remainder of the loan’s duration.