LIBOR: Everything You Need To Know
Cathie Ericson5-minute read
You might not have thought about financial terms since you passed Econ 101 back in high school, but consider this your easy cheat sheet to an important one that could affect how much you’re paying for your mortgage: LIBOR. Read on for everything you didn’t even know you needed to know about LIBOR.
What Is LIBOR?
LIBOR, or the London InterBank Offered Rate, is a benchmark interest rate that is accepted as the definitive global indicator of what borrowing costs between financial institutions should be. Every day, the Intercontinental Exchange calculates and publishes this interest rate as a reference point for banks around the world.
While it’s not an interest rate that you will see as a borrower, it is the interest rate that banks charge each other. That is how it affects your financial life, particularly if you have an adjustable rate mortgage, where payments fluctuate according to interest rates, as opposed to a fixed-rate mortgage.
LIBOR was introduced in 1986 by the British Bankers’ Association (BBA) as a way to create a consistent measurement of interest rates across financial institutions that interacted with each other internationally. It became the default standard interest rate both locally and internationally.
While it has undergone numerous changes over the years, both contracting and expanding as currencies are added or removed, the most major change took place in 2014. It was renamed from BBA LIBOR to ICE LIBOR when the Intercontinental Exchange assumed its administration. And, even more changes are afoot in the financial market, as it is set to be phased out by the end of 2021. (We’ll tell you more about that later on.)
In the meantime, it’s important to be aware of the ways LIBOR can affect your financial life today, whether you know it or not.
LIBOR is used for a number of financial products, including:
- Standard interbank products: These include interest rate swaps, interest rate futures, and forward rate agreements.
- Commercial field products: This category includes syndicated loans, floating rate certificate of deposits and notes, and variable rate mortgages. (And yes, that is how LIBOR affects your mortgage – the USD LIBOR is connected to the prime adjustable rate mortgages and subprime mortgages here in the United States.)
- Hybrid products: Here we are talking primarily about collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs), along with other types of notes.
LIBOR Currencies And Maturities
Each day LIBOR is calculated and reported in a total of 35 different rates, including five currencies and seven maturities.
As the average interest rate at which major banks borrow from each other internationally, LIBOR has to be established globally. There are five active currencies for which LIBOR currently fixes rates. These are:
- U.S. dollar
- British pound sterling (GBP)
- Swiss franc (CHF)
- Japanese yen (JPY)]
And just as mortgages come in different maturities, such as 15-year or 30-year, LIBOR rates are expressed the same way. The seven key maturities are:
- 1 day
- 1 week
- 1 month
- 2 months
- 3 months
- 6 months
- 12 months
What Is The Current USD LIBOR Rate?
Of these 35 potential LIBOR rates, the one that is most common – and is referred to as the current LIBOR rate – is the three-month U.S. daily rate. But, as mentioned it is expressed in a number of ways.
You can check out the current rates at sites like Bankrate or news sites like the Wall Street Journal and compare them to past rates, such as those from a month or year ago, to see if LIBOR is going up or down. For example, on the day we wrote this piece (11/11/2020), here were the rates:
- 1 month LIBOR rate: 0.14
- 3 month LIBOR rate: 0.22
- 6 month LIBOR rate: 0.24
- 1 year LIBOR rate: 0.33
Why Is LIBOR Ending In 2021?
As mentioned above, the LIBOR saga continues with the fact that it is in the process of being phased out by the end of 2021.
Despite being what appears to be a rather dry financial instrument, LIBOR is actually the key player in some fraudulent dealings, which ultimately led to the decision to find an alternative. Why the scandal? It’s because the metric that affects LIBOR is easy to exploit since it is self-reported. Human nature being what it is, the good faith estimates were hijacked by traders who devised ways to manipulate the numbers to benefit them.
In fact, that’s why LIBOR was moved from the BBA to ICE in the first place. But despite tightened rules, it was clear that there needed to be a more forthright and unequivocal option that couldn’t be manipulated. In 2014, the U.S. Federal Reserve Board and the Federal Reserve Bank of New York created the Alternative Rates Reference Committee (ARRC) to suggest reforms. They have since recommended replacement systems, leading to the end date of the LIBOR interest rate benchmark.
Alternatives To LIBOR
There are a number of available alternatives to LIBOR, which largely vary by country. Here are the ones that will affect you as a U.S. financial consumer.
Secured Overnight Financing Rate (SOFR)
The financial world loves its acronyms, and the newest one is SOFR, which is the Secured Overnight Financing Rate. This is what the Fed has recommended as the main replacement to the LIBOR rate, calling it more “sound” and “resilient.”
The reason it appears to be more legitimate and not subject to manipulation is because it is a benchmark rate based on the actual rates banks are charged for their overnight transactions. That means it is more transparent because it is derived from transactions secured by U.S. Treasuries, not unsecured transactions that previously provided the base for the LIBOR rate.
You can find out more about its paced transition here.
But SOFR is not the only game in town – another potentially viable alternative to LIBOR is Ameribor, an interest rate benchmark created by the American Financial Exchange that reflects the actual borrowing costs of banks. It is being billed as an alternative to both LIBOR and SOFR because there are thousands of U.S. banks that do not borrow at those rates to fund their balance sheets. Ameribor is designed specifically for small, medium and regional banks, along with larger financial institutions and small and middle market companies that do business with them.
Just as the U.S. financial industry has developed alternatives to LIBOR and so have other countries. Here are some additional key LIBOR transitions:
- Europe: Euro Short-Term Rate (ESTR)
- Britain: Sterling Overnight Index Average (SONIA)
- Switzerland: Swiss Average Rate Overnight (SARON)
- Japan: Tokyo Overnight Average Rate (TONAR)
The Bottom Line
Being informed about factors that affect your financial life is the first step to improving it. That’s why even though the concept of LIBOR (and it successors) might seem obscure, they do have an effect on the rates you pay, particularly if you have an adjustable rate mortgage.
While those rates (and certainly the behind-the-scenes intrigue that is leading to an alternative to the LIBOR rate) are out of your hands, the one aspect of your financial life that is largely in your control is your credit. After all, the better your credit, the more likely you are to qualify for the best rates, not matter how they are set.
Want to know more about credit and how to improve yours? Read on, with a library of informative credit articles on Rocket HQSM.
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