Gauging rate risk for your Libor-based ARM


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Dear Dr. Don,
I have a rental home with an adjustable-rate mortgage adjusting every August. The rate is based on the Libor, or London Interbank Offered Rate. When the Federal Reserve begins to raise interest rates, will the Libor follow as well? Or will the drop in the value of the euro force Libor to keep rates low?

This rental home was my own home five years ago, but I was forced to move out of the Las Vegas area to relocate for work. I was unable to sell the property and I didn’t want to obliterate my credit by walking away, so I rented it out. I currently subsidize the $100 difference between my mortgage payment and the rental income. I’m still underwater on the property (although better than before), but I am unable to refinance. I figure in a year or two, I may be able to sell it and break even. I fear if the Libor begins to rise that I’ll need to pay more each month. What do you think?

— Steve

Dear Steve,
Think of Libor as the equivalent of the federal funds rate for the U.K. and Europe. Both are benchmark rates that banks charge each other for short-term loans. One important difference is that Libor has seven different maturities, priced in five currencies. Bankrate tracks four of those maturities: the one-month, three-month, six-month and one-year Libor rates. Find out which Libor rate is used in setting your adjustable-rate mortgage, or ARM, interest rate. Determine whether there are any stated floors, ceilings or rate-adjustment caps in the ARM loan agreement.

While the Federal Reserve has ended its quantitative-easing program and is considering its first increase in the targeted federal funds rate since the financial crisis, the European Central Bank has ramped up its quantitative-easing program. The Bank of England has kept its base rate at 0.5 percent since 2009 but is probably closer to raising rates than the ECB.

The risks associated with the use of Libor rates over your fairly short investment horizon of up to two years shouldn’t keep you awake at night. The world’s major economies aren’t going to go from seeking growth to stomping on the brakes by aggressively raising interest rates over a short time period. What’s all this worrying getting you, anyway? You say you don’t have the ability to refinance right now. You’d be better off investing your energy in things you can control.

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