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LIBOR Basics
Is a LIBOR-based loan right for me?
LIBOR – What is it?
History of LIBOR
Scope of LIBOR
How LIBOR is produced
How LIBOR is calculated
Factors that influence LIBOR rates
Where to find LIBOR rates and information
Is a LIBOR-based loan right for me?
A LIBOR-based loan might be right for you if you:
- Have moderate to high income
- Desire to have lower insurance premiums in exchange for higher deductibles
- Have an investment risk profile that indicates tolerance for medium and above risk
- Have variable income, such as commission-based, bonus-, or profit-based
- Are self employed
- Wish to have a high liquidiy ratio
- Have hiquid reserves (at least six months)
People who might typically benefit from a LIBOR-based loan include:
- Jumbo residential mortgage borrowers*
- Small business owners
- Commercial property owners
- Multifamily (e.g., apartment building) property owners
- Medium and large business financial officers
- Young, upwardly-mobile professionals
Like all investments, investments in LIBOR-based products are not for everyone. Though the outcomes can be fruitful, borrowing against the LIBOR benchmark contains a certain risk in that the interest rates can be volatile. Borrowers considering LIBOR-based products should familiarize themselves with the pros and cons of these loans and seek consultation from a qualified professional.
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*Jumbo residential loans are loans over the $417,000 conforming loan limit in most areas. In some areas the conforming loan limit may be as high as $625,000. You can find the conforming loan limit for specific Metropolitan Statistical Areas on the FHA website.
LIBOR – What is it?
LIBOR is the primary global benchmark for short term interest rates. The word LIBOR is an acronym for London Interbank Offered Rate, the interest rate at which large international banks are willing to lend each other substantial unsecured funds on a short-term basis in the London wholesale money market. LIBOR is calculated every business day in 10 currencies and 15 terms, ranging from overnight to one year.
Many loan interest rates, such adjustable home loan interest rates, home equity line of credit interest rates, student loan interest rates, and small business loan interest rates, are often based upon a LIBOR index rate plus a margin (typically 1.5% - 2%). Fannie Mae and Freddie Mac, are among the many lenders that base loan products on this short-term benchmark. Derivative-based products such as credit swaps may also be based upon the LIBOR index.
LIBOR's popularity with lenders in part stems from that fact that:
- It is long established.
- It is a truly international reference rate, and the only international index, as it considers sixteen of the world’s largest banks.
- Its mechanism is transparent. The LIBOR is comprised of a panel of sixteen banks from different countries and institutions that reflect the balance of the market. The BBA then surveys the panel’s market activity and publishes the market quotes. In other words, the formula for determining the LIBOR is easily understood, which creates a check and balance.
- The sixteen banks that comprise the LIBOR rate are the most active in the cash markets and have the highest credit ratings. Banks are selected based on reputation, scale of market activity, and perceived expertise.
History of LIBOR
By 1984, an increasing number of banks were actively trading in a variety of relatively new market instruments such as interest rate swaps, foreign currency options and forward rate agreements.
To sustain and facilitate growth of these markets, the British Bankers Association, in conjunction with other key organizations, recognized a need to implement uniform standards. This set of standards included set BBA interest settlement rates, which ultimately officially became LIBOR on January 1st, 1986.
LIBOR gained popularity in the United States as international investors in mortgage debt wanted to use a rate more in line with their cost of doing business in global markets.
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Scope of LIBOR
According to University of Edinburgh professor Donald MacKenzie, approximately $10 trillion in business loans, mortgages, and student loans worldwide are LIBOR-based and more than half of all U.S. adjustable rate home loans are tied to LIBOR. Many home equity lines of credit are also LIBOR-based. Additionally, vehicles such as short-term interest rate futures contracts, interest rate swaps, inflation swaps, floating rate notes, and syndicated loans are pegged to LIBOR. The total amount of financial contracts based upon LIBOR rates are estimated to be in excess of $300 trillion, roughly $45,000 for every human on the planet.
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How LIBOR is produced
A balanced panel maintained by the BBA which consists of 8 banks determines LIBOR rates. The banks are selected to participate on the panel so as to reflect the composition of the market in terms of country and type of institution. Reputation, scale of market activity, and expertise are also qualifying factors. The BBA takes a survey of market rate quotes from each of these banks. The middle two quartiles of the rates are averaged, resulting in the LIBOR rate. Participating banks are:
- Bank of Tokyo-Mitsubishi UFJ Ltd
- Barclays Bank plc
- Credit Suisse
- Deutsche Bank AG
- HBOS
- HSBC
- Lloyds TSB Bank plc
- Rabobank
- Royal Bank of Canada
- The Norinchukin Bank
- The Royal Bank of Scotland Group
- UBS AG
- West LB AG
- The Bank of America
- JP Morgan Chase
- Citibank, NA
How LIBOR is calculated
LIBOR is calculated based upon the following formula:
Principal x (LIBOR rate/100) x (actual number of days in interest period/360) = Interest Due
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Factors that influence LIBOR rates
LIBOR rates are influenced by several factors, including: Local interest rates, banks’ expectations of future rate movements, the profile of contributor banks, and liquidity in the London markets.
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Where to find LIBOR rates and information
LIBORATED.com. Other resources include the British Bankers Association, Reuters, Thomson Financial, Bloomberg, HSH, Class Editori, IDC, Proquote, Telekurs Financial, Wikipedia, and The Wall Street Journal.
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