In 2017, regulators announced plans to phase out the London Interbank Offered Rate (LIBOR) after traders were found to be manipulating the rate for their own profit. Banks were encouraged to stop entering into new loans in the United States that use LIBOR as a reference rate by December 31, 2021. However, the full phaseout of the LIBOR index has been extended and will take until 2023. Until it is entirely eliminated, LIBOR will still impact the financial lives of millions of Americans who have adjustable-rate mortgages (ARMs) and private student loans.
When LIBOR rates decline, as they have throughout the pandemic, consumers with these types of loans see their monthly payments go down. When those rates increase, consumers take notice for an entirely different reason.
What is LIBOR?
Though it is in the process of being eliminated, LIBOR has long served as the benchmark interest rate often used to determine short-term interest rates. LIBOR is based on the rate that a select group of creditworthy international banks charges one another for large loans.
The index was established by the British Bankers’ Association in 1984, which administered it until 2014. At that time, the Intercontinental Exchange Benchmark Administration took over responsibility. LIBOR continues to be administered by the Intercontinental Exchange, which asks a panel of between 11 and 16 banks the following question:
“At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 a.m. London time?”
Thomson Reuters collects the data, averages it and publishes several rates every morning. The rates, which range in maturity from overnight to one, three, six and twelve months, will continue to be published in U.S. dollars until June 30, 2023. Mortgage lenders normally look at the six-month and the one-year LIBOR for ARM loans.
Why is LIBOR being phased out?
In the aftermath of the Great Recession that occurred from 2007 to 2009, it was discovered that some financial institutions had been manipulating LIBOR through the interest rates they reported. The LIBOR scandal resulted in several banks facing major fines and some individuals facing prison time.
Since then, LIBOR has lost some of its credibility, and transactions based on LIBOR have been decreasing. In August 2017, the U.K.’s Financial Conduct Authority announced that by the end of 2021, LIBOR would be fully phased out. The phaseout has since been delayed but is still moving forward. The organization that administers LIBOR has announced that it will no longer publish the LIBOR index after June 30, 2023.
What will replace LIBOR?
In 2014, the Federal Reserve Board and the New York Fed formed the Alternative Reference Rates Committee (ARRC) to explore how the United States would transition from LIBOR to a new reference interest rate.
LIBOR will be replaced by the Secured Overnight Financing Rate (SOFR), which represents the cost of overnight borrowing collateralized by U.S. Treasury securities in the repurchase market. SOFR is produced by the New York Fed and published each business day. According to the ARRC, SOFR is more resilient than LIBOR and better reflects the rate at which financial institutions borrow money. Unlike LIBOR, SOFR is based on actual lending transactions rather than the rates financial institutions say they would offer funds to each other. This difference should make SOFR more transparent.
How does LIBOR affect loans?
As the rate at which banks lend one another money, LIBOR might seem like it has no impact on ordinary borrowers. But in reality, many financial institutions use LIBOR as a benchmark when setting rates on their own loan products. Here are a few types of loans that may be affected by LIBOR.
Gains in LIBOR are a big deal if you have a mortgage that’s linked to the rate, as about half of mortgages in the U.S. are, according to the Council on Foreign Relations.
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 forms, including the commonplace one-year and 5/1 ARMs. The first number you see represents the number of years you pay a fixed rate (five in this case), and the second number tells you how often the rate is reset (once a year).
If LIBOR is down when the mortgage rate resets, your monthly payment will be lower. If LIBOR is higher, your payment 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.
Throughout most of 2020 and the early part of 2021, interest rates were at all-time lows because of the COVID-19 pandemic. If your ARM rate were to reset during this time, you’d likely see your interest rate — and therefore your payment — decrease.
However, rates are beginning to increase again amid inflation, which means ARM borrowers will see their rates increase with LIBOR or its replacement. To avoid further increases, you have the option to refinance your mortgage into a fixed-rate loan before the ARM adjusts. However, the ability to do that will depend on many factors, such as the equity in your home, your credit standing and your job situation.
If you have an adjustable-rate home equity line of credit (HELOC), as is most often the case, then you’ll also be impacted by LIBOR.
A HELOC is revolving debt, meaning you can borrow and pay back your credit limit during a draw period like a credit card.
HELOCs usually have interest-only payments during the draw period. The interest rates are usually variable and are often based on LIBOR. Borrowers may have a very low minimum monthly payment when LIBOR is low but then see it increase when LIBOR increases.
Private student loans that aren’t backed by the federal government are also typically tied to LIBOR. For example, you might take out a student loan with a rate that’s LIBOR plus 2 percent or LIBOR plus 7 percent. The margin would depend on the creditworthiness of the borrower and/or cosigner.
Just like with mortgages, LIBOR has the greatest impact on borrowers with variable-rate loans. If you have a variable-rate student loan, your monthly payments could increase or decrease each year as LIBOR increases or decreases.
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. Whether you are going with a loan tied to LIBOR or not, you have to pay attention to your credit and to finance charges.
Another type of loan that could be affected by LIBOR is a personal loan, which is unsecured debt. These loans are often used for purposes like consolidating high-interest debt or making a large purchase. Personal loans are usually fixed-rate loans but can also come as variable-rate loans.
A variable-rate personal loan can be attractive when interest rates are especially low since you have lower monthly payments and may be able to pay your loan down more quickly. But as with other types of adjustable-rate debt, if your loan is tied to LIBOR, you’ll see your rate increase as LIBOR increases.
The bottom line
LIBOR has been a fixture in the financial world for nearly four decades, impacting the interest rates on a variety of mortgages and other loans. But due to scandals and market manipulation, LIBOR is in the process of being phased out.
What does this mean for consumers? Once LIBOR has been fully phased out, your variable-rate loans will be tied to a different benchmark. There’s no way to know what this will mean for your interest rates in the future, but you can expect them to continue to trend with the market overall.