LIBOR is an acronym for London Interbank Offering Rate. This is the rate that European banks charge each other for short term loans. A mortgage where the interest rate is based on the LIBOR index is a LIBOR mortgage loan.
One of the biggest decisions about what type of mortgage to purchase is how the interest will be calculated. Traditionally mortgages had fixed rates for the life of a loan and the life of the loan was 30 years.
As interest rates began to skyrocket in the 1970’s and 1980’s lenders and borrowers began to look for ways to reduce the risk to lender and make rates affordable for borrowers. The adjustable rate mortgage (ARM) seemed like the perfect solution. By allowing the interest rate on a long term loan to float based on an financial index, borrowers took on some of the economic risk and lending institutions could offer lower rate loans.
Benefits of LIBOR Loans
For borrowers who intend to sell long before a 30-year loan would be paid off, the incentive of lower adjustable rates looks like a good deal. When the rate is tied to an index like the LIBOR, the rates can be volatile but banks make up for the volatility by charging lower margins. The margin is the difference between the index and the rate you are charged. For example if the LIBOR rate is 5.1% and your margin is 2% then the rate you pay is 7.1%.
Like any other ARM, a LIBOR mortgage will have two caps – the annual rate cap and the life-of-the-loan cap. Usually ARM rates are adjusted annually. The annual cap limits the amount the rate can raise in a given year.
For example, if you took out your LIBOR based mortgage in June 2003 when the LIBOR was 1.124%, you had a margin of 2% and the initial rate stayed fixed for two years then you had a big shock in 2005 when the interest rate was adjusted. The rate you would have been paying would be 3.134% but by June of 2005, the LIBOR rate had jumped to 3.691%. Add your 2% margin to the LIBOR rate and your interest rate went from 3.134% to 5.691%.
If the annual cap on your loan was 2%, then your rate would only go up to 5.134% instead of going to the 5.691% based on the LIBOR and the margin.
The other cap is the life-of-the-loan cap. This is the maximum interest rate that can be charged. If the cap is set at 12% and the LIBOR goes up over 10%, you would still only pay 12%.
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