In an era where acronyms — OMG, LOL, etc. — are increasingly popular, LIBOR comes in pretty low on the list. But these five letters are extremely important in the real estate finance realm, and they could have some impactful real-world impact on homeowners.
What Is the London Interbank Offered Rate (LIBOR)?
LIBOR stands for the London Interbank Offered Rate, which is administered by the Intercontinental Exchange (ICE). Originally, LIBOR was used as a way for banks to determine the interest rate they would use when they lend to each other.
Over time, its purpose has expanded and now, the LIBOR rate is an interest rate that major global banks use as a benchmark when lending to one another. LIBOR has been slowly phased out since 2021, which might affect some consumers.
Here’s why: LIBOR fluctuations can dramatically impact people who have adjustable-rate mortgages (ARMs), as the rate directly affects the interest rate adjustments on these loans. Rises and falls in LIBOR can lead to changes in adjustable interest rates, resulting in varying monthly mortgage payments and making it challenging for borrowers to plan their budgets.
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How Are LIBOR Rates Calculated?
LIBOR is determined by a panel of 15 major banks selected by a group within the ICE, and these banks submit rates based on the interest rate on qualifying transactions of $10 million or more.
If not enough transactions are available, they’re required to derive the number from historical transactions while giving greater weight to more recent transactions.
If there’s not enough transaction data available to set a rate based on the first two scenarios, then the panel submits a rate based on expert opinions that consider market movements and other factors.
Once each member of the panel submits the rate, the ICE takes a trimmed mean approach, wherein the four highest rates and the four lowest rates are thrown out. LIBOR is then calculated based on the mean average of the rates from the remaining seven banks.
The History of LIBOR
Greek banker Minos Zombanakis is credited with creating LIBOR in 1969, when he was looking for an interest rate for an $80 million loan from Manufacturers Hanover to the Iranian Shah. The loan eventually was, and today’s LIBOR index still is, based on the funding costs of several reference banks.
LIBOR 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.
LIBOR was the subject of a major rate fixing scandal that came to light in 2008, which led to a dramatic administration change. Beginning on January 31, 2014, control of LIBOR was moved from the BBA to the ICE Benchmark Administration (IBA) group, and that group has had control ever since.
The LIBOR Scandal
The LIBOR index was rocked by a notable scandal in 2008, when it became clear that brokers were influencing the rate. This raised serious issues about LIBOR’s trustworthiness because the brokers’ actions were based on self-interest rather than market fundamentals.
In the wake of the scandal, regulators began seeking alternatives that provided a more unbiased rate. That led to the 204 creation of the Alternative Reference Rates Committee (ARRC), a group of representatives from the Federal Reserve Board and the New York Fed. This group met with the intention of developing an alternative reference rate for use primarily in derivatives contracts.
LIBOR Transition to SOFR
To create a more objective standard, The ARRC crafted the Secured Overnight Financing Rate (SOFR), an index 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, and 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 estimates based on banks’ submissions, which introduces more volatility. This unpredictability can be beneficial, as it promotes greater market transparency, reduces potential manipulation risks and encourages the development of more robust financial benchmarks.
- The index is backward-looking rather than future based. Its figures are based on trades that have already happened as opposed to an individual’s speculation, giving it greater objective standing.
Whether lenders go with SOFR or a new standard, the LIBOR index will be phased out soon. Fannie Mae, Freddie Mac, and FHA no longer accept mortgages using the Libor index and existing ARMs currently using LIBOR will be converted to SOFR after June of 2023. VA loans have never allowed the use of LIBOR.
How The LIBOR Transition Could Affect Your Mortgage
Homeowners with fixed-rate mortgages may not experience significant differences in the switch away from LIBOR, because their rates are locked in place. But homeowners with adjustable-rate mortgages tied to LIBOR may see changes in their interest rates as they switch to the new benchmark, which could lead to fluctuations in their monthly mortgage payments.
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 note.
If you have an ARM tied to LIBOR, here are some actions you can take:
- Stay informed: Keep track of the transition from LIBOR to SOFR by reading official communications from your mortgage lender or servicer. Understand the timelines and key milestones of the transition process.
- Communicate with your lender: Reach out to your lender to discuss the transition and its potential impact on your ARM loan. Seek clarification on how the switch will be implemented, any changes in interest rate calculation and how it may affect your monthly payments.
- Consider refinancing: Evaluate the possibility of refinancing your ARM loan into a fixed-rate mortgage to mitigate the risks associated with the transition.
The Bottom Line
LIBOR was an index used by lenders as a basis for setting interest rates on many of their loans. For various reasons, LIBOR is in the process of being retired. The preferred replacement in the U.S. is often SOFR, which reflects the costs of secured transactions in the U.S. Treasury repurchase market. If you have an ARM tied to LIBOR, you should see how this will affect your monthly payments.
Now that you know more about the inner workings of the adjustment of mortgage rates, you can consider yourself a confident consumer.
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Joel Reese
Joel is a freelance writer who has written about real estate, higher education, sports and myriad other subjects. He has been published in The Best American Sports Writing series, Details, Spin, Texas Monthly, Huffington Post, Chicago magazine and many other outlets. His website, ReeseWrites.net, features several samples of his work.
