Libor Mortgage Loan Tutorial
April 26, 2004, Revised January 24, 2009, August 17, 2009
This tutorial will answer the following questions:
* What is Libor ?
* What is a Libor ARM?
* What is special about a Libor ARM?
* In what ways are Libor ARMs like other ARMs?
* Why should anyone select a Libor ARM?
* How do you get the information needed to assess a Libor ARM?
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.
A Libor mortgage is an adjustable rate mortgage (ARM) on which the interest rate is tied to a specified Libor index. After an initial period during which the rate is fixed, it is adjusted to equal the most recent value of the Libor index, 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%.
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 ¼% 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 ¼% for only 3/8 of a point. This is an incredible bargain, but the Libor ARMs 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.
Index Risk: In the first version of this tutorial, this was omitted. My presumption, badly mistaken, was that Libor would track Treasury indexes very closely. In 2004 and 2005, one-month Libor, which is the most widely-used of the Libor ARM indexes, was below one-year Treasuries, which is the most common of the Treasury ARM indexes. Differences were in the range of .25% to .50%.
In 2006 until the middle of 2007, this relationship was reversed, with Libor higher by about the same amounts. Starting in August 2007, coincident with the emerging financial crisis and loss of confidence in banks by other banks, the spread widened and became highly volatile. ARM borrowers indexed to Libor were severely disadvantaged. In November, 2008, one-month Libor was more than 3% higher than one-year Treasuries! The spread later fell to about 1-1.5%, still too high.
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.
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.
Because Libor is much higher than it was before the financial crisis, Libor ARMs should be avoided until further notice.
This tutorial will answer the following questions:
* What is Libor ?
* What is a Libor ARM?
* What is special about a Libor ARM?
* In what ways are Libor ARMs like other ARMs?
* Why should anyone select a Libor ARM?
* How do you get the information needed to assess a Libor ARM?
What Is Libor ?
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 index. After an initial period during which the rate is fixed, it is adjusted to equal the most recent value of the Libor index, 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 ¼% 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 ¼% for only 3/8 of a point. This is an incredible bargain, but the Libor ARMs 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.
Index Risk: In the first version of this tutorial, this was omitted. My presumption, badly mistaken, was that Libor would track Treasury indexes very closely. In 2004 and 2005, one-month Libor, which is the most widely-used of the Libor ARM indexes, was below one-year Treasuries, which is the most common of the Treasury ARM indexes. Differences were in the range of .25% to .50%.
In 2006 until the middle of 2007, this relationship was reversed, with Libor higher by about the same amounts. Starting in August 2007, coincident with the emerging financial crisis and loss of confidence in banks by other banks, the spread widened and became highly volatile. ARM borrowers indexed to Libor were severely disadvantaged. In November, 2008, one-month Libor was more than 3% higher than one-year Treasuries! The spread later fell to about 1-1.5%, still too high.
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.
Because Libor is much higher than it was before the financial crisis, Libor ARMs should be avoided until further notice.