London Interbank Offered Rate (LIBOR) is the average rate of interest at which banks borrow money from other banks in the London Interbank Market. This rate is fixed by the British Bankers' Association on a daily basis. Here it is to be noted that this rate was first introduced in the financial markets in 1986. With time, Libor has become a very trustworthy index and currently this rate is set up by 16 international member banks.
Libor is a very much trustworthy and most commonly used index for short-term rate of interest. Libor gives a good indication of the global economic condition and this is a widely accepted rate to determine the rate of interest on a mortgage loan. London Interbank Offered Rates are quoted for 1-year, 6-month and 1-month deposits. Currently the countries that take Libor as reference rate are the United States, United Kingdom, Switzerland and Canada.
Libor may be used to determine the rate on an adjustable rate mortgage (ARM). In case of an ARM, for an initial stipulated period of time, the rate of interest remains fixed. Once that initial fixed rate period is over, the rate of the ARM varies with a specified Libor index. In fact, after the initial fixed rate period is over, the rate on an ARM is equated with the recent value of Libor plus a margin.
Some characteristics of Libor mortgage
Many of you may not think that a foreign rate of interest could have perceptible impact on mortgage rate. But in reality, Libor has appreciable impact on US mortgage rate. Anyways, here we discuss about some features of Libor mortgage-
In case of 30-year fixed rate mortgages, mortgage rates can be lowered down by 0.25% by paying around 1.5 points. Again, in case of a 30-year Libor ARM, mortgage rates can be lowered down by 0.25% by paying around 3/8 of a point. So, Libor ARM indeed offers a very attractive buy down opportunity.
In terms of volatility, Libor index matches the volatility of the short-term US Government securities. Again, it is more volatile than some other indexes such as MTA, CODI and COFI.
- In case of a Libor ARM, for an initial stipulated period of time, the mortgage rate remains fixed. For Libor ARM, the initial fixed rate period may range from 6 months to 10 years.
- Once the initial fixed rate period is over, the rate on Libor ARM adjusts every 6 to 12 months. In case of a 3/1 ARM, the rate remains fixed for the first 3 years. Once that 3-year period is over, the rates adjusts every year.
- There are limits to rate adjustments in ARMs. The limits of adjustments are 1% on 6-month Libor ARM and 2% on 1-year Libor ARM.
In case of ARM – Libor or any other-indexed- if the interest saving in the initial low rate phase is more than risks of interest rises later on, then only it makes sense to opt for ARM.