LIBORATED for 10 years
A timeline comparison of using a LIBOR loan versus a fixed rate

June 3, 2009

LIBORATED is dedicated to the premise that intelligent borrowing using loans based on the LIBOR index can create cash flow advantages and long-term savings. Let’s put our premise to the test with the following case study. While this is a hypothetical scenario, the borrower, the property, cash management, and investments discussed are a composite of actual experiences known to the LIBORATED staff. The interest rates used during this timeline study are historically accurate.

We begin in 1999. While the world grimaces in anticipation of the Y2K bug, Mark Collins of Calabasas, CA, is feeling positive. His financial services firm based in Los Angeles’ San Fernando Valley has been growing for the past decade. Nearly 1,000 people work for Mark at the main location and satellite offices across the country. Mark is ready to convert the fruits of his labors into a new home for himself, his wife and two children. They have picked out a 4,500 square foot home on a 2.5 acre parcel. The home’s rustic design with exposed wood beams blends beautifully with its natural surroundings in a canyon that wends through the hills toward Malibu.

The sale price for Mark’s dream home is $1.2 million. Mark has a 20% down payment and seeks a loan of $960,000. It is August, and the conforming loan rate is 7.94%; however, Mark’s house is priced well above conforming loan limits. It is in the “super jumbo” range and commands an interest rate premium above conforming. The best rate Mark can find for a 30-year fixed mortgage at his price point is 8.7%. This translates into a monthly payment of $7518.07.

Mark investigates another mortgage option, an adjustable rate loan based on the 1-Month LIBOR index. LIBOR stands for London Interbank Offered Rate, an average of interest rates that designated banks offer other banks when borrowing for their institutional needs. The 1-Month LIBOR is the rate for interbank loans in U.S. Dollars, 30 days in duration. Mark’s monthly payment would be a 1.5% margin above the 1-Month LIBOR figure for that given month, with a cap of 12% maximum interest rate, should LIBOR spike to over 10%. The loan is interest-only for the first 10 years, resulting in a lower payment than a standard interest+principal payment.

Mark carefully considers the factors of a LIBOR loan:

• The rate varies from month to month
• LIBOR is sensitive to economic and political events, which is why is it used as a barometer of market mood and direction
• Per the above, when the market is confident, LIBOR will be lower. When the market is spooked (yes, there is psychology at work here), rates will increase
  
• Based on past LIBOR performance—which is an indicator but not a guarantee—there could be many months out of the year when mortgage payments would be significantly less with a LIBOR loan versus a fixed rate loan
• Cash flow during months of low payments could be used for other investments and needs
• Cash reserves are highly advisable to offset higher payments during months when LIBOR is elevated

Mark weighs the options and decides in favor of the LIBOR loan. As a business owner, he understands cash flow management. He has acted aggressively but prudently in building his company, always having a “plan B” during lean months. As the California real estate market begins to heat up in 1999 after its slump at the beginning of the decade, Mark is considering buying investment properties. The positive cash flow potential with the LIBOR loan on his primary residence will help him in these acquisitions. In turn, Mark carefully sets aside a special account for the inevitable months when his mortgage payments will rise.

When Mark closes the deal on his $1.2 million home in the summer of 1999, the 1-Month LIBOR stands at 5.37%. With his 1.5% margin, Mark’s first monthly interest rate is 6.87%, resulting in a payment of $5,496, $2,000 less than the fixed rate loan he considered and on track with his target monthly payment of $5,500.

Approximately one year later, however, the financial advantage between LIBOR loan and fixed rate essentially vanishes. November 2000, the American presidency hangs in the balance along with chads in Florida. Nobody is sure if George W. Bush or Al Gore is the new commander-in-chief. The markets roil with the uncertainty, and 1-Month LIBOR shoots to 6.827%. Mark’s monthly rate and payment: 8.327%, $6,661.60. Mark draws on his cash reserves to cover the difference between his budgeted mortgage payment ($5,500) and his current amount. He sits tight on his plans to buy investment properties and waits with the rest of the world to see who will occupy the Oval Office.

Fast forward another year, and current events become even more dire and momentous. Markets freeze and fall after the 9/11 attacks. However, LIBOR is down considerably from its 2000 levels, with the 1-Month LIBOR at 2.321% in October 2001. Mark’s monthly rate and payment: 3.821%, $3,056.80. Governments and central banks begin efforts to bolster the economy, which include lowering interest rates.

In 2002 and 2003, LIBOR settles into a lull with rates for the 1-Month LIBOR index hovering in the 1% range. It reaches record lows in June 2003. Mark’s payment at this point: 2.5%, $2,000. Mark buys two 1,400 sq. ft., three-bedroom houses as income properties. Purchase prices for the homes are $315,000 and $337,500. Mark puts down 20% on each home and takes out LIBOR-based mortgages of $252,000 and $270,000.

Mark’s initial numbers on the income properties:

• Investment (down payments): $116,000
• Monthly mortgage payments at onset (interest only, first 10 years): $1,087.50
• Property taxes and insurance, pro rated per month: $520
• Monthly rent income: $2,900
• Tax deductable upkeep and maintenance expenses, monthly average: $195
• Straight line depreciation on the structures, prorated per month: $1088

In the first month, Mark sees a positive cash flow of $1,292.50 and tax benefits of $1,283 from his $116,000 investment. The cash flow will vary based on LIBOR rates and occupancy levels.

By the middle of the decade, LIBOR starts to move back up. Some experts warn of a real estate bubble as prices and purchases reach a fevered pitch in the United States and other countries. Soon a new term enters the global financial conversation: toxic mortgages. In June 2005, the 1-Month LIBOR is 3.3401%, creating a monthly interest rate and payment for Mark of 4.8401% and $3,872.08. He is still well below his budgeted $5,500 a month but begins to pull back on plans for more real estate investing. Mortgage payments on his two income properties are $2105.44. Rent income is $3,263 per month with the tight California real estate market propping up rental rates and boosting appraised values. Mark is still in the black on this investment, but his profits have decreased.

Roughly one year later, July 2006, 1-Month LIBOR is 5.4045%, its highest point of that year. With an interest rate that month of 6.9045%, Mark pays $5,523.60 on his primary home mortgage and is prepared to turn to his cash reserves per his earlier discipline.

During 2007, the few who warned of financial turmoil are hailed as prophets as the credit markets grind to a halt and housing plummets. Throughout the year, Mark uses cash reserves to cover overages in his mortgage payment. In September, 1-Month LIBOR hits its high point of 5.72%, resulting in a 7.22% interest rate and $5,776.00 payment. Mark takes comfort that he would still be paying approximately $2,000 more for the month had he selected a super-jumbo fixed-rate loan back in 1999. Monthly mortgage payments on his rentals are $3140.70.

In 2008, the woes of the mortgage and housing industries spread to all sectors. In the fall, Lehman Brothers does just that. However, 1-Month LIBOR has receded during this season to an October rate of 3.92625%, translating into a monthly rate and payment for Mark of 5.42625% and $4341. He is back within his budgeted range for mortgage payments. Market turmoil is leading him to consider new opportunities carefully.

Approaching the halfway mark of 2009, LIBOR has declined to historically low levels. While the economy remains treacherous and certain sectors and businesses continue to reel and collapse, the market overall responds to forceful actions from central banks. Interbank lending rates ease as institutions become more confident in making loans. In May 2009, 1-Month LIBOR comes in at 0.31313%. Mark’s numbers on his primary residence: 1.875% and $1,500.

Mark’s rental properties’ combined monthly payment: $870.27. His occupancy rate has been excellent given the shifting fortunes in the Southern California economy that have put more people into the rental market.

Mark takes advantage of the combination of renewed cash flow and lower real estate prices by purchasing a multi-unit residential property in Venice, CA, for $2,850,000 with 30% down payment. The loan of $1,995,000 is tied to the 1-Month LIBOR plus a margin of 2.50% with an initial interest-only option. The note rate of 2.875% translated into a monthly payment of $4,780. The six units produce $19,500 per month income against the operating expenses of $5,100 resulting $9,620 initial monthly cash flow sheltered by $5,937 monthly depreciation.

As Mark approaches the 10-year anniversary of the purchase of his primary residence, he reviews the numbers:

• 1-Month LIBOR average for time period: 3.38%
• Average mortgage interest rate: 4.88%
• Average monthly payment: $3,904
• Total payments during time period, based on average: $468,480
• Total payments under super-jumbo fixed-rate mortgage, based on monthly payment of $7518.07: $902.168.40
• Current monthly income on investment property portfolio: approximately $12,400.
• Monthly operating expenses and depreciation on investment property portfolio eligible for tax benefits: approximately $12,200.

Mark will watch the markets and trends closely. He will check LIBOR rates regularly. He knows that the interest-only phase of his primary home mortgage is soon ending, but he has used this important decade of lower house payments to create a real estate portfolio that will bring him income, taxation and asset benefits for years to come. Mark has a beautiful home for his family and holdings for their future security because he was LIBORATED.

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