What Is LIBOR? Definition, Rate And More
Banks use various benchmarks to set their interest rates. The federal funds rate is always in the news right now. Another bellwether rate of the past has been LIBOR. Although it’s no longer widely in use, loans and lines of credit tied to it have been undergoing a transition. We’ll talk LIBOR, its effects and why it’s being phased out.
What Is LIBOR?
LIBOR stands for the London Interbank Offered Rate. The Intercontinental Exchange (ICE) is responsible for the administration of the rate. Originally, LIBOR was used as a way for banks to determine the interest rate they would use to lend to each other. Over time, its purpose has been expanded.
LIBOR is an interest rate that major global banks use as a benchmark when lending to one another. Since the end of 2021, LIBOR is being phased out, a process that may impact some consumers.
LIBOR Rate History
Minos Zombanakis is credited with the creation of LIBOR. He was looking to come up with an interest rate for an $80 million loan from Manufacturers Hanover to the Iranian Shah in 1969. The loan was, and today’s LIBOR index still is, based on the funding costs of several reference banks.
Banks began to use LIBOR as an index. It became more formalized in 1986 when the British Bankers’ Association (BBA) took control. The index was reported for the U.S. dollar, British pound and Japanese yen starting that year.
We’ll get into more detail below, but LIBOR was the subject of a major rate fixing scandal that came to light in 2008. One of the aftereffects of that was an administration change. Beginning January 31, 2014, administrative control of the LIBOR index was moved from the BBA to the ICE Benchmark Administration (IBA) group. They’ve had control ever since.
How Is LIBOR Used?
LIBOR is losing its prominence as a benchmark interest rate due to the scandal. While it’s being phased out altogether, it has been and is still used in some cases to set rates for the following:
- Forward-rate agreements: In these agreements, a bank borrows money from another bank with the understanding that in the future, it’ll pay money back at a certain interest rate.
- Commercial loans: LIBOR served as the basis for the interest rate on certain loans to businesses.
- Consumer borrowing: LIBOR was often the index for calculating the new interest rates on things like adjustable-rate mortgages (ARMs) and even some student loans.
How Is LIBOR Calculated?
The LIBOR rate is based on a panel of 15 major banks selected by the IBA. They are instructed to base the submitted rates on qualifying transactions in the amount of $10 million or more and what the interest rate was.
If not enough transactions are available, they’re required to derive the number from historical transactions, with more recent transactions being given greater weight, while adjusting for market movement.
If there’s not enough transaction data available to set a rate based on the first two scenarios, then the bank is supposed to submit a rate based on expert opinion, considering market movements and the information given by brokers, among other factors.
Once the rate is submitted by each member of the panel, the IBA takes a trimmed mean approach. The four highest rates and the four lowest rates are thrown out. LIBOR is calculated based on the mean average of the rates from the remaining seven banks.
Does LIBOR Affect My Mortgage?
LIBOR probably won’t affect anyone’s mortgage for much longer because there’s currently a transition to other benchmark rates. However, until the transition is complete, ARMs could still be using LIBOR as an index.
When an ARM tied to LIBOR is set to adjust, the LIBOR index on that date is added to a margin to come up with the new rate in effect until the next adjustment. The interest rate change may also be limited based on upward or downward caps in movement specified in your mortgage contract.
If you have a fixed-rate mortgage, LIBOR and rates like it won’t have an impact. Your fixed-rate is based on your personal and financial characteristics, but also movement in the market for mortgage-backed securities. Although your payment may fluctuate with changes in taxes and insurance, your actual interest rate doesn’t change.
If you currently have a mortgage with adjustments indexed to LIBOR, be on the lookout for communication from your lender and/or servicer regarding updates to your benchmark for interest rate changes.
Why Is LIBOR Being Phased Out?
The LIBOR model relies on banks reporting what they think borrowing costs will be between the banks. This was a fundamental flaw that was exposed and led to the uncovering of a rate-fixing scandal.
There’s a lot of really good reporting on this if you want to know more. Essentially, because brokers were the ones making the deals, they often told the people at the bank responsible for submitting rates what they wanted the rate to be.
This becomes a problem because it’s based on self-interest rather than market fundamentals. In the wake of the scandal, people began to look for alternatives and tried to determine how to move forward in the meantime. A viable replacement has come into use in the U.S.
SOFR Vs. LIBOR
The Secured Overnight Financing Rate (SOFR) is the replacement for LIBOR used by many in the U.S. The index is based upon what banks are charged for a U.S. Treasury repurchase agreement overnight. The rate is an average of the reported rates at banks. SOFR has a couple of factors that make it less vulnerable to manipulation than the LIBOR index.
- It’s less predictable than LIBOR. Because it’s based on actual trades, SOFR is tied to market movement rather than someone’s guess as to what’s going to happen.
- The index is backward-looking rather than future based. The trades have already happened in the past rather than being based on someone’s idea of what might happen next.
Whether lenders go with SOFR or something else, LIBOR will be phased out by June 2023 under the current timeline.
Other Regional Interest Rates
LIBOR may have been a trendsetter when it comes to basing an interest rate on a panel of banks, but it’s helped give rise to several similar indexes around the world including:
- European Interbank Offered Rate (EURIBOR)
- Tokyo Interbank Offered Rate (TIBOR)
- Mumbai Interbank Offered Rate (MIBOR)
- Shanghai Interbank Offered Rate (SHIBOR)
The Bottom Line
LIBOR was an index used by lenders as a basis for setting interest rates on many of their loans. Banks on the panel are asked to predict, based upon a set of guidelines, what they think the cost of borrowing from each other in the short term will be. After throwing out some outliers, the average of the predictions makes up LIBOR.
LIBOR is in the process of being retired. In 2008, LIBOR was the subject of a major rate fixing scandal. Since then, replacements have been sought. The preferred one in the U.S. is often SOFR, which is tied to repurchases of U.S. treasuries. If you have an ARM tied to LIBOR, your mortgage lender should be reaching out to you to go over the changes for your adjustment index.
Now that you know more about the inner workings of the adjustment of mortgage rates, you can consider yourself a confident consumer. If you’re looking to check out your mortgage options, apply online or call us at (833) 230-4553.