Today, I’ll cover everything you need to know about the LIBOR rate and how it may affect you.
What does LIBOR mean?
The word “LIBOR” is actually an acronym that stands for “London Inter-Bank Offered Rate.”
What is the LIBOR?
The LIBOR is considered the benchmark interest rate for banks all across the world, dictating the rate and cost of lending money to each other. These rates can refer to the cost of lending bank-to-bank overnight, over the course of one month, three months, six months, or one year.
Of course, the current LIBOR is watched and tracked by millions of financial institutions, lenders, economic analysts, and even governments around the world. That day’s LIBOR is published by Reuters each day at exactly 11 a.m.
Reuters also announces that day’s LIBOR in five currencies: the U.S. dollar, Swiss franc, euro, UK pound sterling, and the Japanese yen.
How is the LIBOR calculated every day?
Before 2014, the LIBOR rate was set by a group called the British Bankers’ Association. They asked a set panel of banks from all the world how much they would charge that day to lend another bank a sum of money, in their own currency and for a particular period (overnight, one month, etc.).
These currency quotes for lending the formulated that day’s LIBOR.
However, on August 4, 2015, responsibility for the LIBOR was moved from the British Bankers’ Association to the ICE Benchmark Administration (ICE). ICE still computes that day’s LIBOR based on lending quotes from member banks, but also includes an oversight panel of anywhere from 11 to 18 banks. Still, the LIBOR is essentially calculated the same way.
Of course, individual banks tack on a “point” or two on top of the LIBOR rate when issuing loans like mortgages to consumers, which builds in their profit.
History of the LIBOR
The LIBOR was first created in the mid-1980s, in the wake of the savings and loan crisis that rippled through the U.S. and international banks. Looking for a reliable and stable way to standardize interest rates, the first LIBOR rate was rolled out in 1986.
Why the LIBOR is so important.
So why should be concern ourselves with some esoteric financial index that foreign banks use? Actually, the rise or fall of the LIBOR permeates across financial markets worldwide with a direct and significant impact on consumers.
That especially includes homeowners because most adjustable rate/interest-only mortgage loans are calculated based on the LIBOR. In fact, when the LIBOR rises even incrementally, homeowners could potentially see a shocking payment due on their next monthly statement! A good number of home equity line of credit (HELOC) mortgages are also tied to the LIBOR index.
The LIBOR also helps guide banks around the world set interest rates for issuing credit cards, as well as some car loans or even education loans.
Likewise, when the LIBOR goes up, consumers are mandated to pay more. In total, the British Bankers’ Association estimates that more than $350 trillion in loans and financial products are affected by a rising LIBOR. (Let that number sink in for a moment!)
LIBOR influence on an institutional level.
The LIBOR serves many functions, and that includes calculations on credit default swaps and interest rate swaps. Essentially, those are both financial vehicles for banks to insure against loan defaults (and massive mismanagement of these helped contribute to our past financial crisis, as we’ll learn.)
How a rising LIBOR affects the economy.
When the LIBOR rises, the cost of borrowing basically goes up across the board. Even if you don’t have a loan tied to the LIBOR index, you’ll feel the effects. That’s because any increase in the cost of lendings acts like pumping the brakes on a car, slowing growth, reinvestment, and lending. Subsequently, the economy stops growing as quickly, consumer demand shrinks, unemployment goes up because companies don’t need to (or want to) hire as much, and everything slows.
Of course, that’s not unexpected nor unhealthy, as the economy is continually in a state of ebb and flow to obtain a balance between growth and inflation. But if the LIBOR remains high for a prolonged period, it could cause a recession.
What will a higher LIBOR mean for you?
If you have an adjustable rate, interest-only, or HELOC home loan, chances are that your payment will go up once the LIBOR rate rises. However, different loans have different timelines and stipulations for when, how, and how much your interest rate can go up based on LIBOR changes.
But remember that an increase in the LIBOR typically means a loan reset for you. That’s so important because some people may find themselves stuck in a loan with a swelling payment.
Additionally, your credit card payments could go up significantly, too, as well as other loans.
Together, they can put a significant pinch on your monthly budget.
Big changes to the LIBOR are coming:
Plagued by a 2012 scandal and questions about its validity and stability, the LIBOR looks like it may be soon retired. In July 2017, the United Kingdom’s Financial Conduct Authority went public with the news that they were looking to phase out the use of the LIBOR by 2021.
As banks have slowed down lending to other financial institutions, the sample size is just too small and inconsistent to create a sound basis for setting the LIBOR rate.
Instead, the Bank of England and others are looking for better alternatives, such as the Sterling Overnight Index Average or the Euro lending rate.
In the United States, the Alternative Reference Rates Committee is considering using their own index for dollar rates that is based on something called “repo trades” that have Treasuries as a foundation.
Reportedly, the LIBOR will begin to phase out as soon as 2019.
What should you do if you have a home loan tied to the LIBOR (or aren’t sure)?
If you have an adjustable or interest-only loan, it’s best to contact me. I can review your lending documents and tell you if your loan is tied to the LIBOR, or if a rising index will have any influence on your payments. If that’s the case, you may be able to refinance into a more stable home loan that isn’t affected by the LIBOR.
It doesn’t hurt to ask questions, and I’m happy to help!