LIBOR: The Global Benchmark for Lending Rates
LIBOR is an abbreviated term for London Interbank Offered Rate.
What It’s Used For:
- LIBOR helps establish lending rates for banks around the world for short-term rates on loans between banks. But it is also used to set terms on interest rates between other lenders and borrowers on variable rate debt (which can run the gamut from corporations seeking loans or individuals applying for credit cards). For example, a credit card is considered variable rate debt because banks can reset rates higher under certain conditions, such as when consumers make several late payments, or after the timeframe of a “promotional rate” expires – or when LIBOR rises. In recent years, as interest rates in the U.S. have gone up, albeit off historical lows, the average rates charged on card borrowings have also gone up, by a few percentage points.
- A higher LIBOR generally means higher payments on corporate and consumer loans, credit cards, mortgages, and even complex financial instruments such as interest rate swaps. An interest rate swap would be considered complex because, as a transaction between corporate entities, the terms of the transaction can vary depending on the parties involved and involve both variable and fixed rate interest payments.
- Regardless of complexity, these instruments all have one thing in common: rates can be recalculated over the lifetime of the loan. A lower LIBOR can mean that terms on adjustable rate debt – such as adjustable rate mortgages (ARMs), where rates on outstanding balances can change — can be reset lower, which in turn translates into lower interest payments. For example, a 7/1 ARM is a mortgage that has fixed interest rates in place for the first seven years; the rate can then reset after the seventh year and thereafter is resent annually. If LIBOR is lower when the fixed term ends, the rates can reset lower, saving borrowers money.
What It Is
LIBOR is a standard interest rate used by international banks when lending to each other over short periods of time—from overnight to as long as one year.
LIBOR is also used as a reference rate for other financial products, including but not limited to credit cards, some personal loans, and some mortgages.
How It Is Calculated
The Intercontinental Exchange (or ICE, an electronic exchange based in Atlanta and focused on commodities) polls a number of banks representing five currencies —the U.S. dollar, the Euro, the Japanese yen, the British pound sterling, and the Swiss franc — about the rates they would charge other banks for short-term lending activities.
These currencies are combined with seven maturities (overnight, one week, one month, two months, three months, six months, and 12 months) to created 35 LIBOR rates. These rates are calculated daily and then collected by a number of banks active in London’s IBA (ICE Benchmark Administration) money market at 11:45AM GMT.
Some LIBOR rates are published by various media outlets, predominantly by Thomson Reuters and The Wall Street Journal. Published rates are calculated using a “trimmed mean.” This method helps blunt the impact of outliers from the polls. It eliminates the highest and lowest rates on offer from the banks and uses an arithmetic average for the remaining rates – the goal is to smooth out the impact of “extreme” rates that may be offered by banks.
Though there are 35 separate LIBOR rates, the rate most often used is the three-month U.S. dollar rate.
Why LIBOR Is Important
LIBOR is used by lenders to help them decide what interest rates to charge on everything from mortgages to corporate loans to currency swaps. Essentially, LIBOR is the lowest rate of interest that will be charged on commercial borrowings.
Generally speaking, lenders will use LIBOR to help calculate the rates they will charge, which for variable rate debt (where interest rates may fluctuate over time, such as with credit cards or some student loans) will be recalculated after a set amount of time during the life of the loan.
Lenders can and often do often charge an additional rate on top of LIBOR. You may see this rate written as a percentage or basis points. Basis points (bps or bips) are an industry short-hand for discussing rates — 100 basis points equal one percent. This is commonly referred to as “LIBOR plus,” and is how you’ll most commonly see LIBOR used on the YieldStreet platform.
In a hypothetical example, a two-year real estate loan has an interest rate of eight percent plus LIBOR. At the time the offering goes live, the LIBOR (note that it is quoted as an annualized rate) rate is two percent. This means the initial total interest rate would be 10 percent. If the LIBOR rate later increases to three percent, the total interest rate would increase to 11 percent.
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