What is replacing LIBOR for mortgages?
LIBOR affects the interest rate for numerous financial products including mortgages and particularly adjustable rate mortgages or ARMs. For many borrowers, LIBOR directly impacts their monthly loan payments -- if LIBOR increases, their payment does too -- so it is an important financial benchmark.
Over the course of 2020, however, lenders are going to stop using LIBOR and the mortgage rates for ARMs and similar programs will no longer be based on LIBOR. Below we explain the rate that is replacing LIBOR, what this change means borrowers and answer key questions about the transition.
What is LIBOR?
LIBOR stands for London Interbank Offered Rate, which is basically the average interest rate that banks charge each other to borrow funds. Although the L stands for London, LIBOR is used by banks all around the world, including the United States.
LIBOR is considered a reasonable approximation for how much it costs banks to borrow money. LIBOR fluctuates based on changes in the economy and other factors. The more expensive it is for banks to borrow from each other, the higher LIBOR is.
What mortgage programs use LIBOR?
Adjustable rate mortgages (ARMs) -- also known as variable rate mortgages -- are the most common type of loan that uses LIBOR. Some interest only loans and home equity lines of credit also use LIBOR although these programs are less common and not subject to the same guidelines as ARMs. In short, if your monthly payment is subject to change on a monthly, semi-annual or annual basis, your mortgage program may use LIBOR.
You can review your mortgage documents to determine if your loan uses LIBOR. Specifically, the documents for an adjustable rate mortgage contain a rider that outlines how your mortgage rate and monthly payment are calculated over the course of the loan. An ARM rider should note if the mortgage uses LIBOR.
How does LIBOR affect your mortgage rate for these loan programs?
The mortgage rate you pay for ARMs and similar loan programs is usually calculated by adding two components: the index and the margin. The margin is a set rate that does not change over the course of the mortgage. In most cases, the ARM margin ranges from 2.000% to 3.000%.
The index is an underlying interest rate that changes based on economic conditions and other inputs. Many ARMs use LIBOR as the index. The ARM index plus the margin equals the mortgage rate you pay, which is also sometimes referred to as the fully-indexed rate. For example, if the ARM margin is 2.000% and LIBOR -- the index in this case -- is 1.500%, your mortgage rate is 3.500%.
If an index, such as LIBOR increases, your mortgage rate increases. If the index decreases, your rate decreases. If the index is zero -- which is highly unlikely -- your rate is the margin.
This is why any changes in the mortgage rate for an adjustable rate mortgage depend on only the index and why LIBOR is such an important rate for many borrowers. A higher LIBOR means a higher mortgage payment and a lower LIBOR means your payment goes down.
Why is LIBOR being eliminated?
Over the past decade, regulators determined that LIBOR was subject to manipulation by banks and other financial institutions. This means that the rate may not be an accurate measure of banks’ borrowing cost.
For this reason regulators also decided that LIBOR should not be used to determine your mortgage rate. In short, your monthly mortgage payment should not be based on an underlying rate that can be influenced by a small number of unscrupulous individuals.
When did mortgage programs stop using LIBOR?
As early as 2014 regulators decided that LIBOR should be eliminated but because the rate is used by so many financial products and institutions the timetable to transition to a new rate spanned several years. The percentage of mortgages that use LIBOR has declined and lenders cannot offer LIBOR-indexed ARMs after September 30, 2020.
When is LIBOR going away for good?
LIBOR will no longer be published after 2021.
What is replacing LIBOR?
For most adjustable rate mortgages, LIBOR is replaced by the Secured Overnight Financing Rate or SOFR for short. SOFR is published by the Federal Reserve Bank of New York. Most ARMs use the 30-day average SOFR as the index to calculate the mortgage rate.
How is SOFR determined?
It is a little complicated, but in short, SOFR represents the overnight cost for banks to borrow money using U.S. treasuries as collateral for the loan. SOFR was developed to be more transparent than LIBOR and significantly more challenging to manipulate.
In general, however, SOFR and LIBOR serve a similar purpose and assess banks’ borrowing cost. As borrowing becomes more expensive for banks, SOFR increases and as borrowing becomes less expense, SOFR decreases.
When are SOFR-indexed adjustable rate mortgages available?
Lenders should start offering SOFR-based ARMs to borrowers in the second half of 2020. As of October 1, 2020, all ARMs should use SOFR to calculate the fully-indexed mortgage rate.
The table below shows ARM loan terms for leading lenders in your area. We recommend that you contact multiple lenders to learn more about the adjustable rate mortgage programs they offer. Shopping lenders is also the best way to save money on your mortgage.
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Besides switching from LIBOR to SOFR, are adjustable rate mortgages changing in any other way?
There are multiple changes to ARMs as a result of implementing SOFR as the index, which we summarize below:
Following the initial fixed rate period -- which is three, five, seven or ten years -- SOFR-based ARMs adjust every six months, or semi-annually, as opposed to annually for LIBOR-indexed ARMs. These programs are known as 3/6, 5/6, 7/6 and 10/6 ARMs or hybrid ARMs.
Because SOFR-indexed ARMs adjust twice a year, the rate change cap after the initial change is 1% instead of 2%.
Because the 30-day average SOFR is typically lower than LIBOR, the SOFR-indexed ARMs usually use a higher margin of 3.000% as compared to approximately 2.000% for LIBOR-based ARMs, although the fully-indexed rate (ARM margin plus the index) should be relatively consistent.
If my mortgage uses LIBOR, what happens when it goes away?
Most mortgages contain a provision that enables the lender to change the index if it is no longer available. This is also known as “fallback language.” We recommend that you review your mortgage note and specifically the ARM rider to determine how your fully-indexed rate is calculated when LIBOR stops being published.
In most cases if your mortgage is currently indexed to LIBOR it will likely be indexed to SOFR when LIBOR is no longer available. Your other mortgage terms, however, should remain the same.
Sources
"Overview of the ARRC’s Proposed Models of SOFR ARMs." Domestic Market Operations. Federal Reserve Bank of New York, 2019. Web.
"SOFR Averages and Index Data." Domestic Market Operations. Federal Reserve Bank of New York, 2020. Web.
"Important Updates to Adjustable-Rate Mortgage (ARM) Products." LL-2020-01. Fannie Mae, February 5 2020. Web.
"Important Single-Family Updates on the LIBOR-SOFR Transition." Single Family. Freddie Mac, November 15 2019. Web.
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