What Is LIBOR And How Did It Affect My Mortgage Rate?

Recently phased out in the United States, LIBOR rates impacted how much consumers paid for their mortgages for more than 40 years.

The discontinuation of LIBOR affected some adjustable-rate mortgages, reverse mortgages, home equity lines of credit, credit cards, auto loans and student loans, as well as other personal loans that used LIBOR as the index.

So what exactly is LIBOR, and what does it stand for? Let’s take a closer look at this term and its impact on the mortgage market over the years.

LIBOR, which stands for the London Interbank Offered Rate, is an index that was commonly used in establishing the interest rate for many adjustable-rate consumer financial products. An index is a benchmark rate that reflects market conditions.

LIBOR was heavily used for a variety of loans in the United States up until 2022. At one point, there were an estimated $1.3 trillion in consumer loans with an interest rate based on LIBOR, with the bulk of the debt coming from residential mortgages.

But how did LIBOR work, and why was it phased out? Let’s find out.

Understanding How LIBOR Rates Worked

When you apply for a mortgage, you might wonder what factors affect the rate you pay. The first metric lenders checked to price various types of ARM loans used to be LIBOR, which served as a “base.” Then to more accurately determine your interest rate, they would also consider factors like your credit score; debt-to-income ratio (DTI); amount of down payment and more.

The LIBOR rate wasn’t the amount you’d see in your interest calculation, as it was what banks charged each other, not individual borrowers. Instead you’d be charged an interest rate indexed to LIBOR and based on your specific circumstances, which impacted the lender’s judgment about your ability to repay your loan – in other words, how much risk they believe they were taking on according to your past experience with credit and repaying your bills.

For example, your rate might have been stated as LIBOR + 2, with the LIBOR part as the index, which would vary with economic changes, and the “2” (or whatever number you were assigned based on your specific risk factors) as the margin, which would stay the same.

But here’s why it only affected certain types of mortgages. As you were shopping for your loan and talking to a professional about the right financial product for your situation, you were likely offered a wide variety of mortgage loan products, including adjustable-rate mortgages (ARMs) and fixed-rate mortgages.

Many homeowners choose an ARM, particularly in higher-priced housing markets, because they prefer the lower monthly payments that ARMs offer during the early part of their terms. Non-fixed interest rate payments were generally tied to the LIBOR benchmark, which is why this index played a large role in how much interest you pay on your mortgage if you had an ARM.

With an index so broadly used, you might assume it had been around forever, but it actually wasn’t introduced until 1986 by the British Bankers’ Association (BBA). However, it quickly became the default standard interest rate at the local and international levels.

Despite this wide adoption, LIBOR had a number of shortcomings and was tainted by scandal and fraud. That’s due to its nature that made it easy to exploit. Since LIBOR is based on self-reporting and good faith estimations by participating banks, traders figured out ways to manipulate it for fraudulent purposes.

When the scandal broke revealing this deception in 2012, the BBA transferred regulatory oversight of the LIBOR rate to British regulators as part of the Financial Services Act 2012. It also tightened the repercussions and deemed it a criminal offense to make deliberate or knowing statements that were related to setting the LIBOR benchmark.

Even after the new rules, financial regulators decided there needed to be a new option and preparations were soon underway to find an alternative to the LIBOR rate. In 2014 the U.S. Federal Reserve Board and the Federal Reserve Bank of New York created the Alternative Rates Reference Committee (ARRC) in order to review potential replacements for LIBOR. In 2017, the ARRC made its recommendation, and the UK’s Financial Conduct Authority followed up with a planned LIBOR phase out after 2021.

Ever since January 2022, LIBOR has not been used to issue new loans in the U.S.

So what happened next, you ask? Introducing “SOFR,” the Secured Overnight Financing Rate, recommended by the Fed as the replacement to the LIBOR rate.

SOFR is a benchmark rate that uses the rates banks were actually charged for their overnight transactions, and therefore is harder to manipulate because it is based on actual loans. In other words, the transactions are secured by U.S. Treasuries, rather than the unsecured transactions that were used to set the LIBOR rate.

But not everyone is happy – lenders in particular don’t feel that SOFR is as predictive as LIBOR. Therefore, adoption of SOFR was slow, even though the mortgage industry had no choice but to use it effective January 3, 2022.

So now that LIBOR has officially been phased out, you may be wondering if, and how, the change affected you. If you previously had a fixed-rate loan, you wouldn’t have been impacted by the discontinuation of LIBOR.

The only way you might have experienced this change is if you previously had an adjustable-rate loan or line of credit based on LIBOR, as your lender would have needed to change to a different index around the date of discontinuation. It’s possible that you experienced movement in your interest rate on your mortgage and other loans due to the change in index. However, the mortgage industry had been working to ensure there would be minimal changes to your monthly payment.

It’s important to stay on top of any changes that are occurring in the mortgage space so that you’re able to ask the necessary questions about your loan contracts for any financial products and make sure you understand the ins and outs and how various changes might affect your bills.

It’s also smart to check interest rates in case your credit has improved or there’s been another financial change in your life that might have boosted your credit worthiness, thus allowing you to qualify for a lower interest rate.

If you have questions related to the LIBOR rate or any aspect of your mortgage or the home buying process, speak with our Home Loan Experts today.