What's a LIBOR?

Dear Dr. Don,
I was asked about an interest rate on a loan I am getting. The person asked me if it was based on LIBOR or prime. I have no idea what they are talking about. Could you tell me? -- Tracy Tripped

Dear Tracy,
Variable-rate loans are priced at a spread to an underlying interest rate. A home equity line of credit could be priced at prime plus 2, meaning the prime rate plus 2 percentage points. It should represent the short-term interest rate that banks charge their best customers. That definition has been somewhat malleable with time, but that's the gist of a prime rate. Bankrate tracks The Wall Street Journal's prime rate on its Rate Watch page along with most interest rates that lenders use to price variable (adjustable) rate loans.

LIBOR is the acronym for London Interbank Offered Rate. It is the rough equivalent of our banking system's fed funds rate. Home equity lines of credit can also be priced on LIBOR, where changes in LIBOR cause the interest rate to change on the loan.

Some pricing indexes or rates react faster to changing interest rates than others. That can be advantageous in a downward rate environment, but works against you when interest rates are trending higher. COFI, the 11th District Cost of Funds Index, has been a popular index for adjustable-rate mortgages because of its stability in upward rate environments. Both LIBOR and the prime rate will move rapidly in a changing interest rate environment.

If you don't know the index or pricing spread on your loan, make it your mission to find out before you close on the loan. Along with that you need to know how often your interest rate is reset and any limits on interest rate changes either for a single reset period or over the life of the loan.

With mortgage loans you can often get a hybrid loan that has the interest rate locked for a period of time before the first reset date. A 5/1 ARM, for example, is an adjustable rate mortgage that has a fixed interest rate over its first five years and then resets annually.

Dear Dr. Don,
How do I evaluate adjustable-rate loans based on LIBOR vs. T-bill vs. prime? Which type of loan do I want?
-- Gary Grasp

Dear Gary,
I'm not sure you want an adjustable-rate loan. Short-term interest rates are trending higher and the interest rates on adjustable rate mortgages will trend higher with increases in the interest rate that the mortgage is priced on.

I like ARMs in downward rate environments and when I don't plan on being in a home for all that long. Hybrid ARMs like a 3/1, 5/1 or 7/1 ARM can mitigate the interest rate risk while still giving you a lower initial interest rate than a 15- or 30-year fixed-rate mortgage.

The Fed has already started to tighten credit with five quarter-point increases in the targeted fed funds rate this year. It's a little late in the game to be jumping on the adjustable rate mortgage bandwagon. A stable index like COFI will mitigate some of the risk short-term, but it's a tough call if you plan on being in this house for a long time.

Try using Bankrate's Mortgage Adviser with its interactive worksheet on adjustable-rate mortgages to determine if an adjustable rate mortgage is right for you.