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

“LIBOR” is one of those financial terms that you might tend to skip over and decide it doesn’t apply to you, but believe it or not, it might be affecting how much you pay for your mortgage. Here’s everything you need to know about the London Interbank Offered Rate and your finances. 

LIBOR is a widely used interest rate benchmark. Despite its established history, it will be phased out after 2021, a change that could affect many adjustable rate mortgages (ARMs) and other consumer loans in the United States.

Although it’s being phased out due to scandals and fraud, it’s still in wide use today. And if you have an ARM, it’s likely affecting your interest rate, as LIBOR rates are used as a standard of where interest rates are going, consulted by lenders all around the world as a predictor of future loan costs. It’s a benchmark rate based on the average interest rate a group of leading global banks estimate they would charge each other for short-term loans, known as a “reference rate.” Lenders then use that to calculate the rate you pay, which we’ll explore more below.

Currently the LIBOR rate is calculated for five currencies and different loan period lengths, from 1 day to 1 year.

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

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

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

But here’s why it only affects 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 (FRMs).

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 are generally tied to the LIBOR benchmark, which is why this index currently plays a large role in how much interest you pay on your mortgage if you have an ARM.

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

But, despite this wide adoption, LIBOR had a number of shortcomings and has been 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 make its recommendation, and the UK’s Financial Conduct Authority has followed up with a planned LIBOR phase out after 2021.

What’s 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, and it doesn’t yet have a mechanism to allow lenders to look up future rates. Therefore, adoption of SOFR has been slow, even though the mortgage industry will have no choice but to use it effective January 3, 2022.

While it’s primarily used in corporate financial transactions, currently LIBOR is also written into many consumer loans which means that the switch might affect those borrowers.

In fact, it is estimated that there are approximately $5 trillion in consumer loans based on LIBOR. This includes financial products such as credit cards, student loans, car loans and personal loans, along with ARMs. While fixed-rate mortgages won’t be affected, it’s estimated that about half of the $1 million-plus mortgages are ARMs based on LIBOR rates. That’s a sizable percentage of U.S. loans, many of them concentrated in geographic areas where housing is expensive and homeowners are carrying jumbo mortgage balances.

If you have a loan set to LIBOR, during the transition, you might see some movement in your bills as your loans could be affected (as well as your credit card interest rates), and that could affect your budget if you typically carry large balances. However, huge swings aren’t expected, and yet it’s always wise to be prepared.

The good news is that you still have time to see how this will affect you – and it’s smart to find out. First, check your mortgage contract to find out if your mortgage is an ARM and if so, whether it is indexed to LIBOR. Then you’ll want to find out whether there is a rate cap on your maximum monthly payment; in other words, an amount your payment can’t go over, no matter how much the interest rate rises.

If you’re currently applying for a mortgage or consumer loan, ask whether it’s indexed to LIBOR and if so, find out how the LIBOR phase-out will affect your loan. You’ll want to know what that maximum payment might be, in case of uncertainty during the switch-over.

If uncertainty concerns you, you might want to consider whether choosing a fixed-rate loan for your mortgage or refinance, or an ARM that is not linked to LIBOR, might be right for you. Again, while no one knows the actual difference, it’s not expected to be huge, but a fixed-rate product might be more appropriate if you want peace of mind about the steadiness of your bills as you forecast future budgets.

It’s important to get a clear picture of what your payments will be now and in the future, as well as to consider other “pros and cons” of various types of loans in order to make the decision that’s right for your financial situation.

It’s hard to believe that an obscure (to most) index from England could affect your bills. And it’s important to understand that while no one has yet predicted that it will cause your payment to rise, that uncertainty in a financial situation can be disconcerting.

The main thing to do is always ask 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 a good time to revisit your mortgage and consider your alternatives before changes occur. There may be a mortgage plan out there that can lower your monthly payment, even before the LIBOR phase-out begins.

It’s always 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 to one of our mortgage professionals today.