Libor is short for the London
InterBank Offered Rate, the interest rate offered for U.S. dollar
deposits by a group of large London banks. There are actually several
Libors corresponding to different deposit maturities. Rates are quoted
for 1-month, 3-month, 6-month and 12-month deposits.
What Is a Libor
Mortgage?
A Libor mortgage is an adjustable rate
mortgage (ARM) on which the interest rate is tied to a specified Libor. After
an initial period during which the rate is fixed, it is adjusted to
equal the most recent value of the Libor plus a margin, subject to any
adjustment cap.
For example, on April 26, 2004, one
lender was offering a 6-month Libor ARM at 3%, zero points, and a margin
of 1.625%. The new rate 6 months later will be 1.625% plus the 6-month
Libor at that time. If that is (say) 2.625%, the new rate will be 1.625%
+ 2.625% = 4.25%. If the adjustment cap that limits the size of rate
changes is 1%, however, the new rate will be only 3% + 1% = 4%.
Special Features of Libor
Mortgages
Low Margins for A-Quality Borrowers:
Libor ARMs were developed to meet the needs of foreign investors looking
to minimize their interest rate risk on dollar-denominated investments.
A foreign bank that buys the 6-month Libor ARM containing a 1.625%
margin can borrow the funds it needs in the inter-bank market for 6
months at the 6-month Libor. The bank pays the depositor Libor, and it
earns Libor + 1.625% on the ARM. The margin is locked in, except to the
extent that changes in Libor are not fully matched by changes in the ARM
rate because of rate caps.
Because of the reduced risk,
investors in Libor ARMs are willing to accept a smaller margin than is
common on other ARMs. On April 26, 2004, for example, the Libor margin
available to A-quality borrowers was as low as 1.50%, compared to 2.25 �
2.75% on ARMs indexed to other series.
But not everyone can benefit from the
low margin. On the same day that the lender cited above was offering a
6-month Libor ARM at 3% with a 1.625% margin, a sub-prime lender was
offering a 6-month Libor ARM to borrowers with D-credit at 10% with a 7%
margin!
Attractive Buydowns:
On 30-year fixed-rate mortgages,
borrowers can usually "buy down" the rate by �% by paying about 1.5
points. I have seen 30-year Libor ARMs that allow the borrower to buy
down the rate and margin by �% for only 3/8 of a point. This is an
incredible bargain, but the Libors that offer it may have an unusually
high maximum rate.
No Negative Amortization:
Libor ARMs don�t offer the payment
flexibility, nor the associated risks, of negative amortization ARMs.
High Index Volatility:
Libor is about as volatile as rates on short-term US Government
securities, and more volatile than the COFI, CODI and MTA indexes.
Common Features of
Libor Mortgages
The remaining features of Libor ARMs
are very similar to those of other ARMs.
Initial rate period. This is
the period during which the initial rate holds. Initial rate periods on
Libor ARMs range from 6 months to 10 years.
Subsequent adjustment period.
This is period between rate adjustments after the first adjustment. For
example, an ARM on which the initial rate holds for 3 years and is then
adjusted every year is a "3/1". Most Libor ARMs adjust every 6 or 12
months.
Rate
Adjustment Caps: Rate adjustment caps that limit the
size of a rate change are generally 1% on 6-month Libors, and 2% on
1-year and 3-year Libors. On 7 and 10-year Libors, the cap is usually 5%
on the first adjustment and 2% on subsequent (annual) adjustments. On
some 5-year Libors, however, the adjustment cap is the same as that on
1-year and 3-year Libors, while on others it is the same as on 7-year
and 10-year Libors.
Maximum Interest Rate:
This is the highest interest rate allowed on the ARM over its life. The
maximum rate on some Libor ARMs is set at 5% or 6% above the initial
rate. On others it is set at an absolute level � 11%, for example,
regardless of the initial rate.
Why Select a Libor
Mortgage?
You select a Libor loan not because
it uses Libor but because it has a combination of other features that in
combination add up to an attractive ARM for you. An ARM is attractive
if, during the period you expect to have the mortgage, the interest
savings early in that period (relative to a FRM or an ARM with a longer
initial rate period) outweigh the risk of interest rate and payment
increases later on.
The best way to make such a judgment
is by using interest rate scenario analysis. An interest rate scenario
is an assumption about what will happen to rates in the future. Usually,
we focus on rising rate scenarios, because those are the ones we worry
about.
For any given scenario, we can
calculate exactly how high the rate and payment will go, and when it
will get there. Using the same scenario, we can compare different ARMs,
as well as ARMs against an FRM. We can also calculate the cost of an ARM
or FRM over any period specified by the borrower.
Because their margins can be small,
borrowers who take Libor ARMs may find it attractive to reduce the risk
of future rate increases by adopting the FRM payment strategy. This
involves making the payment they would have had to make had they chosen
an FRM, for as long as the FRM payment remains above the Libor ARM
payment.
To see a sample of rates/payments and
costs on an ARM and an FRM under different scenarios, including results
for an FRM payment strategy, click on
Sample Rates/Payments and Costs
.
Information Needed to Assess a Libor
Mortgage
You get it in two steps. In step 1,
you have your loan officer or mortgage broker provide the essential data
on the features of each loan you are considering. To make it as easy as
possible for them, print out and give them
Worksheet of ARM Features.
In Step 2, you transfer the data on ARM features into the
ARM Tables calculator which will generate your tables. Have your
data in hand before clicking on ARM Tables calculator above or selecting
the ARM Tables calculator on the Tutorials Menu.
