banking

Libor: What it means for US consumer loans

Financial chart
Highlights
  • Libor has a direct impact on adjustable-rate mortgages to private student loans.
  • This international rate is set every day and is used as a reference rate around the world.
  • In the past, Libor moved almost in lock step with the U.S. bond market.

You may not think a foreign interest rate could impact the interest you pay in the U.S., but it does. From adjustable-rate mortgages to private student loans, the London Interbank Offered Rate, or Libor, has a direct effect on the amount you pay.

"Your payment may go up or down if it's tied to the Libor," says Tisa Silver-Canady, assistant director at the office of Financial Education and Wellness at the University of Maryland.

Libor is the rate a select group of creditworthy international banks charge each other for large loans. It is set by Thomson Reuters in conjunction with the British Bankers' Association.

This international rate is set every day and it is calculated based on rate information provided by a panel of 16 banks.

In case you haven't heard yet, most of these banks are now under the spotlight in one of the biggest banking scandals of all times, for alleged manipulation of the Libor. Only one bank, Barclays, has admitted wrongdoing so far but at least 11 banks are under investigation.

Why is this scandal a big deal? The Libor is used as a reference rate for borrowing and lending around the world. It is the most widely used benchmark for short-term rates and is used in the U.S., Canada, Switzerland and London. About $10 trillion in loans, including mortgages, student loans and credit cards, are tied to the Libor.

The Libor interest rate maturities can range from overnight to 12 months. Mortgage lenders normally look at the six-month and the one-year Libor for ARM loans.

1-month and 1-year Libor compared to the federal funds rate, 2007 to present*

1-month and 1-year Libor compared to the federal funds rate, 2007 to present

Source: Bankrate.com

*The London Interbank Offered Rate is the rate that a select group of creditworthy international banks charge each other for large loans. The federal funds rate is the rate at which U.S. banks lend money to each other overnight.

Libor reflects global finance world

In the past, Libor moved almost in lock step with the U.S. bond market, which meant if the bond market was down, so was Libor, says Kevin Luss, owner of The Luss Group Inc., a financial services firm in Southampton, N.Y. But Luss says the spread between Libor and U.S. bond rates has widened in recent years. He says that can be attributed to U.S. financial firms relying more broadly on the international markets to access money.

Silver-Canady says American lenders are using rates from overseas as a result of the global financial push. "A lot of banks do business with each other overseas, and the Libor is reflective of the global financial world we are in," she says.

ARMs impacted by Libor

For the vast majority of mortgage borrowers, what Libor is doing on any given day doesn't matter. But if you have an adjustable-rate mortgage, or ARM, it does. An ARM is a type of mortgage tied to an economic index, mainly Libor. With an ARM, you lock in an interest rate, typically a low one, for a fixed period. Once that period ends, the mortgage resets to the current interest rate of that index. ARMs come in many flavors, including the commonplace one-year and 5/1 ARMs. With a one-year ARM, you pay a fixed interest rate for the first year and then the reset interest rate each year thereafter. With a 5/1 ARM, you pay a fixed rate for the first five years, and then the mortgage rate is set for one-year terms until it's paid off.

If Libor is down when the mortgage rate resets, your monthly payment will be lower. If Libor is higher, your premium each month will rise. The difference in Libor may not mean much to someone who has enough money to handle an increased mortgage payment, but for people just getting by, a rising Libor can be devastating.

You have the option to refinance your mortgage into a fixed-rate loan before the ARM adjusts, but the ability to do that will depend on many factors such as the equity in your home, your credit standing and your job situation, Walters says.

"If you have equity, pretty good credit and a job that can support the payment, there's no problem whether it's an ARM or a fixed loan," Walters says. When refinancing into a new product, the past product has no bearing on your new approval, he says.

Student loan rates move with Libor

Private student loans that aren't backed by the federal government and are tied to Libor also are beholden to it.

Silver-Canady says many banks will lend money to students with rates that are tied to Libor. For instance, you may take out a student loan with a rate that's Libor plus 2 percent or Libor plus 7 percent. The difference in percentages is based on the creditworthiness of the borrower and/or the co-signer, Silver-Canady says. And just as with ARMs, when the Libor is up, your student loan payment will be higher. When it's down, it will be lower. Libor won't have any bearing on a fixed-rate federal student loan.

Understanding the impact of the Libor on interest rates will make you a savvier borrower when you're looking for a mortgage or student loan.

According to Silver-Canady, whether you are going with a loan tied to Libor or not, you have to pay attention to your credit and to finance charges.

"People don't look at the interest rate. They only look at the sticker price," Silver-Canady says. "How much you borrow today in order to finance a purchase and what you end up paying fluctuates, depending on the interest rate."

 

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