The UK has announced plans to end the London interbank Offered Rate (Libor) at the end of this year. Mohamed Dabo looked into what it means for the average Jane and Joe
Libor is the basic rate of interest used in lending between banks on the London interbank market. It is also used as a reference for setting the interest rate on other loans.
Libor is therefore an index commonly used in setting the interest rate for many adjustable-rate consumer financial products.
An index is a benchmark interest rate that reflects market conditions.
Why it is being abandoned
Libor is based on transactions among banks that don’t occur as often as they did in prior years, making the index less reliable and credible. The FCA, UK regulator that oversees the Libor panel, has decided that it cannot guarantee Libor’s availability beyond the end of 2021.
Across the globe, governments and financial institutions have been working to identify alternatives.
What will replace it?
In the U.S., the Federal Reserve has convened a working group called the Alternative Reference Rates Committee (ARRC) to help facilitate the likely transition away from LIBOR.
The ARRC is comprised of a diverse set of private sector entities, and a wide array of official sector entities (including regulators such as the CFPB) as non-voting ex-officio members.
The ARRC has recommended an index called the Secured Overnight Financing Rate (SOFR) as its recommended alternative to Libor and has published a transition plan to promote the use of SOFR on a voluntary basis.
How the end of Libor will affect the consumer
Many different adjustable-rate products use Libor. Adjustable-rate mortgages (ARMs) are the most common.
There are an estimated $1.3trl in consumer loans with an interest rate based on Libor. The bulk of the debt is for residential mortgages.
This change will affect some adjustable (or variable) rate loans and lines of credit like adjustable-rate mortgages (ARMs), reverse mortgages, home equity lines of credit, credit cards, auto loans, student loans, and any other personal loans that use Libor as the index.
Effect on your interest rate
When you take out a loan or line of credit, the amount you borrow is called the principal. Interest is an amount you will pay over a certain period of time to borrow the money.
Your interest rate is the interest you are being charged, expressed as a percentage of your principal. The amount of interest you will pay over the life of your loan and in your monthly loan payment is determined by your interest rate (and other loan terms).
For adjustable rate loans and lines of credit, lenders typically calculate your interest rate using two numbers: the index and the margin. The index is a benchmark interest rate that reflects market conditions, and changes based on the market.
There are many indexes in the marketplace. Currently, common indexes include Libor, the US Prime Rate, and the Constant Maturity Treasury Index (CMT).
You can look up rates for common indexes in newspapers or online.
The margin is the number of percentage points added to the index by the lender to get your total interest rate.
Index + Margin = Your Interest Rate
For example, you could have a mortgage with an interest rate of Libor, plus 2%. Or you might have a credit card with an interest rate equal to the U.S. Prime Rate, plus 9%.
If I have a loan or line of credit based on Libor
If you have a loan or line of credit based on Libor, your lender may change to a different index, likely around the anticipated date of Libor’s discontinuation.
If you’d like to check whether your loan or line of credit may be impacted, you can look at your loan contract. Your loan contract tells you whether your interest rate is fixed or adjustable.
If it’s adjustable, the contract should list which index is used to calculate your interest rate.
If you have questions about the impact of this transition on your loan or line of credit, you can call your lender or servicer for more information.
Because lenders and servicers are currently planning for this transition, they might not have answers to all of your questions at this time.
More information will be available as the transition gets closer.
If you are shopping for an adjustable-rate loan or line of credit
If you’re in the market for an adjustable-rate loan or line of credit and you choose a product that uses a Libor-based index, your initial loan index will be Libor.
But your lender may change to a different index, likely around the anticipated date of Libor’s discontinuation.
As with any other financial decision, ask questions and consider your options before you agree to loan terms:
- Request quotes from at least three different lenders.
- Ask lenders about the various loan options they offer, including fixed interest rate options.
- If you are considering an adjustable rate loan, make sure you are confident you know what your maximum payment could be and that you can afford it.
The Financial Stability Board (FSB) today published a global transition roadmap for LIBOR. The roadmap sets out a timetable of actions for financial and non-financial sector firms to take in order to ensure a smooth Libor transition by end-2021.