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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.
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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.
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.
LIBOR Rate vs SOFR
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.
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.
Wrapping Things Up
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.