On this page
One of the terms many investors will hear when it comes to lending is the LIBOR rate. The London Interbank Offered Rate, or LIBOR, has long been an important tool in determining the cost of borrowing money. Yet, as an investor, a few things are necessary to understand about it and how it could impact buying decisions.
What Is LIBOR?
LIBOR is called a benchmark interest rate. That means that it is used as a starting point for other banks to make decisions about how much they will charge. Specifically, it is the rate that large, global banks charge one another to borrow money. It typically applies to only international interbank markets and is usually only used for short-term loans.
When an investor borrows money from a bank, that bank has likely obtained funds from another bank. LIBOR is the benchmark rate that describes borrowing costs between those banks.
How Is LIBOR Used?
The LIBOR rate has long been used as a benchmark rate. That is, it is used to gauge the up and down movements in interest rates across the market. The rate, administered by the Intercontinental Exchange (ICE), is just one component in the cost of borrowing.
LIBOR can be used for various types of interest rate calculations. Typically, it is used for commercial and consumer loan terminations and is applicable around the world. Financial institutions use this benchmark rate as a starting point, tacking on fees and other costs to it. These rates can then be used for everything from adjustable-rate mortgages, car loans, credit cards, and so on.
The adjustable rate mortgage is typically based on this benchmark rate. That is, as the rate adjusts, it typically follows what is occurring with this benchmark rate, moving up or two as applicable.
While LIBOR is often thought of as a rate related to borrowing, it is also tied to some mutual funds. That means that if an investor puts money into these funds, the change in value or interest rate will be dependent on the changes in the LIBOR rate, impacting how much the mutual fund’s value will change.
There are various ways that LIBOR is used today. This typically includes an impact on various types of financial products, including the following:
- Commercial products, including floating rate certificates of deposit as well as notes. It can also impact commercial variable rate mortgages, such as those many investors use to purchase real estate. It impacts syndicated loans as well, which typically is a type of loan that is lent by more than one lender.
- All standard interbank products will follow the LIBOR rate to some degree. This includes forward rate agreements, interest rate swaps, and interest rate investments like futures and options.
- Consumer loan related products are also based on the LIBOR rate in some situations. This typically includes individual mortgages as well as student loans.
- Hybrid loan products may also be impacted by changes in LIBOR rates, including collateralized debt obligations, accrual notes, perpetual notes, and callable notes. Collateralized mortgage obligations follow suit as well.
How Is LIBOR Calculated?
The calculation of LIBOR has come under question in recent years. Generally speaking, ICE will ask major international banks what they charge other banks for these types of short-term loans. They then report this information.
The method of calculation of the LIBOR rate is called the Waterfall Methodology. This is a standardized method that is quite complex, built on layers of information, and typically data-driven. It is also based on transactions.
Every day, ICE requests this information from global banks. Then, they remove the highest and the lowest numbers from that list. Using the remaining data points, they then create an average. This is often called the trimmed average.
Once this information is complete, ICE will then post the information. It changes daily – this is not a static figure but is considered more of a floating rate. Most of the time, ICE will post this rate around 11:55 am London time. This is done by the ICE Benchmark Administration (IBA).
Current LIBOR Rates
When it comes to making decisions for investment purposes, it is critical for investors to know what this floating rate is. Remember that this rate can often change, which is why it is important to have this information updated frequently. The LIBOR rate is a common benchmark interest rate. It is possible to find out what the current LIBOR rates are by doing a bit of research online.
However, LIBOR is based on factors such as length. In March of 2023, these were some of the most up to date LIBOR rates:
- 1 Month LIBOR Rate: 4.73
- 1 year LIBOR Rate: 4.99
- 3 Month LIBOR Rate: 4.94
- 6 Month LIBOR Rate: 4.97
Other indexes exist as well. This information changes often and must be considered at the time of decision making.
Why Is the LIBOR Rate Being Discontinued?
By June 30, 2023, the LIBOR rate will be phased out. That is because, according to the US Federal Reserve and UK regulators, the rate is far too subjective. These regulators found that the rate can be manipulated, and the methodology can be critiqued.
Also notable is that there have been some scandals related to the LIBOR rate in recent times. All of these reasons have made the rate more subjective and, as such, it is less credible and less used than it used to be.
Alternatives to the LIBOR Rate
Due to the concerns about the accuracy and benefits of this floating interest rate, LIBOR alternatives are now available and commonly used. For example, the EURIBOR, or European Interbank Offered Rate, is one such similar rate. The TIBOR, or Tokyo Interbank Offered Rate, is another. The MIBOR is the Mumbai Interbank Offered Rate, and the SHIBOR is the Shanghai Interbank Offered Rate in China.
The End of LIBOR: How Does It Affect You?
The change in LIBOR may not have a significant impact on investors unless the SOFR rates are much different than what is expected now. Generally speaking, there are other factors that are likely to impact investment decisions beyond this. The switch will be applied in the US and UK, but other countries use their own rating mechanisms.
Things To Note
The LIBOR rate is one of the more important factors to consider when trying to understand how much it will cost to borrow money. It is one component of the total cost that investors may pay since this is the rate banks charge each other – not what the consumer or commercial lender pays to borrow money.
Yet, understanding the fluctuations in the LIBOR rate may help investors to make better decisions about how to invest and how the type of loan they obtain will apply to their bottom line profits for any project.
For all commercial investors, mortgage interest rates are a critical factor in the profitability of any industry. These rates tend to move alongside key benchmark rates, but their ultimate determination is whether or not an investment to them seems to be worthwhile.
Fixed rate loans do not change throughout the lifetime of the loan, but adjustable rate mortgages do. These typically follow a key benchmark rate, often the Secured Overnight Financing Rate, more commonly known as SOFR. Understanding SOFR is critical before making any investment decision.
What is Secured Overnight Financing Rate (SOFR) Rates?
SOFR is a rather complex benchmark ranking. It is based on the cost of borrowing that U.S. banks engage in overnight. It is defined by the U.S. Treasury repurchase agreements. These are often called repos.
The London Interbank Offered Rate (LIBOR) rate was commonly used for this but has since been phased out. SOFR is the recommended benchmark rate recommended by the Alternative Reference Rate Committee, also known as ARRC.
Why is SOFR Replacing Libor Rates?
LIBOR was used as a benchmark for setting interest rates for various types of financial products for a long time. It was calculated across five currencies and was used to price adjustable rate mortgages. This benchmark rate was determined based on the submissions from 18 international banks on what they thought rates should pay.
It is important to note that Libor was never set based on the actual cost the banks paid to borrow funds but on what they expected to pay if they did so. That meant that banks could submit lower rates in a way to manipulate these interest rates.
SOFR is being phased in as a replacement. That is because it is a much more resilient rate compared to LIBOR. The method by which it is calculated is more reliable than the LIBOR rate. This makes it an ideal replacement.
How is SOFR Swap Rates Calculated?
SOFR is based on the Treasury repurchase agreements, which are short-term lending contracts that are based on some form of collateral.
If you are wondering how is SOFR calculated, the New York Federal Reserve calculates SOFR by focusing on the 50th percentile of transactions that span a total of three specific markets. These are three repurchase agreements that are collateralized by the Treasury. That includes tri-party repo data. It also includes general collateral finance repo agreements and bilateral treasury repo transactions.
This information is then published by the Federal Reserve out of New York at 8 am each business day. This is one of the most significant differences in the SOFR and LIBOR rates since it is published overnight. It is a fully secured rate. The current SOFR rate is 5.06% according to the New York Fed.
Pros and Cons of SOFR Rates
Another way to gather information on this type of structure and how the swap rates impact decisions made by investors and lenders is to look at the advantages and disadvantages of SOFR rates.
There are notable benefits to SOFR. The first is that it is more resilient and more accurate based solely on the way it is determined. SOFR is based on a better understanding of the market based on the actual transactions taking place within it. There are $1 trillion in daily transactions used to calculate this information – which is a very valuable level of detail.
Another benefit is that SOFR rate is seen as a better representation of the market. It provides an approximate cost of carrying deposit accounts. It provides a more accurate representation of the cost to carry risk free assets. While SOFR is based on actual information, LIBOR is more of an estimated figure, which means it may not hold true in the long term.
Another advantage of SOFR is that it is less at risk of being manipulated. LIBOR can be manipulated, which is why some organizations have turned away from using it. However, SOFR is based on transactions that can be verified, and that means that no one is making decisions about estate borrowing rates like with LIBOR.
There are some drawbacks of SOFR, though. The first is that it can be more volatile at the daily level. However, when looking at longer terms, including compounded and term SOFR, those are more stable. Lenders using this information for various financial factors are not likely to use a single day’s data, though, making those volatile spikes less worrisome overall.
Another disadvantage of SOFR in some situations is that it is less credit sensitive. SOFR is a secured rate, whereas LIBOR is an estimation of the lending costs between financial institutions. The credit risk in SOFR is related to the risk of U.S. treasuries.
A final drawback is that rates are not looking forward but looking backward. They are not focused on what is to come but on what has already happened.
SOFR vs Other Benchmark Rates
Other benchmark rates exist, though they are not heavily used. For example, Bloomberg Short Term Bank Yield Index, or BSBY, is another option. It offers more of the credit sensitivity that LIBOR offers, and SOFR does not. However, it may not be as robust as SOFR.
Another option is to consider AMERIBOR, which is the same type of benchmark rate from the American Financial Exchange. It is also credit sensitive, as is AXI. Another option is the prime rate, which has been used for a long time related to credit cards and home equity loans. It is a federal funds rate.
How Do SOFR Rates Affect Borrowers and Lenders?
Understanding how SOFR works is critical to all borrowers and lenders, but the ultimate goal is to understand the implication of lending. This is the new benchmark rate, which means it impacts all of the financial products most lenders offer.
Most often, borrowers are not likely to notice any significant difference in terms of the overall lending process. Financial institutions will see the brunt of the difference in this changeover. Lenders will need to communicate about how rates are calculated, and there is likely to be a shift in rates, especially related to adjustable rate consumer products.
Things to note
SOFR is a significant switch from LIBOR rates, but it aims to provide more accuracy and a better understanding of market conditions int For investors and borrowers, it will be important to expect a shift in pricing related to the move to SOFR.
SOFR vs LIBOR Rates
The Secured Overnight Financing Rate (SOFR) is the replacement of the LIBOR rate. This is a similar type of benchmark interest rate. It is used for dollar-denominated loans. It will also apply to derivative contracts.
It is different than the LIBOR rate. The SOFR swap rates are based on actual transactions observed by the US Treasury. That is different than just asking the bank what they would charge. This aims to make this information more accurate.
There are several differences between SOFR and LIBOR rates. As an investor, consider the following differences:
- LIBOR is a bank-to-bank lending rate that will include some level of credit risk. SOFR is a risk-free rate, which does not include credit risk.
- LIBOR rates are unsecured, while SOFR is secured using the U.S. Treasury.
- SOFR is transaction based, which is very different from LIBOR, which is based on information submitted by banks based on a limited amount of transactions and relies heavily on judgments made by industry leaders.
- SOFR focuses on more than $1 trillion in daily trading transactions in the overnight repo market. LIBOR is based on $500 million of actual transactions in daily trading based on three months of the wholesale funding market.
- SOFR is very much a backward-looking format, focused on overnight transactions. It does not focus on the future like LIBOR does.
- Also important is that SOFR is only based on the U.S. dollar, while currency options for LIBOR are more extensive to include the U.S. dollar but also other currencies.