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The London Interbank Offered Rate, or LIBOR, has long been a key benchmark for setting the interest rates charged on adjustable-rate loans, mortgages, and corporate debt. While LIBOR is still in use around the world, it is gradually being phased out. By July 2023, LIBOR will be replaced in the U.S. by the Secured Overnight Financing Rate (SOFR).While LIBOR may not be as prominent as it once was, it may still affect some consumer loans and certain types of business loans. Here’s what you need to know about LIBOR, how it’s calculated, how it affects loan rate, scandals surrounding LIBOR, and alternatives to LIBOR.
What is LIBOR?
LIBOR, which stands for the London Interbank Offered Rate, is a benchmark rate that’s used to calculate interest in a variety of financial contracts. It’s been used around the world for decades, and shows up in commercial loans, small business transactions, as well as some consumer products like variable rate mortgages and student loans. When a loan rate moves up or down, a changing LIBOR rate is partially responsible. For example, if you have an adjustable rate mortgage, the rate has likely been set by using LIBOR and adding an additional percentage to arrive at your actual interest rate. Other factors such as your credit score would also be taken into consideration.
How Does LIBOR Work?
LIBOR is based on the following currencies:
British pound
Euro
Japanese yen
Swiss franc
U.S. dollar
The most commonly quoted rate is the three-month U.S. dollar rate, usually referred to as the current LIBOR rate.Additionally, LIBOR offered the following maturities:
Overnight
One week
One month
Two months
Three months
Six months
12 months
The combination of five currencies and seven maturities leads to a total of 35 different LIBOR rates calculated and reported each business day.
How is LIBOR Calculated?
Each day, the Intercontinental Exchange (ICE) asks roughly 18 global banks at what rate they would be able to borrow funds from another bank. They are not asked what they would actually pay, but, instead, what they would anticipate to pay. ICE takes out the highest and lowest figures, then calculates the average from the remaining numbers. This is known as the trimmed average. This rate is posted each morning as the daily rate. Once the rates for each maturity and currency are calculated and finalized, they are announced and published once a day at around 11:55 a.m. London time by the ICE Benchmark Administration (IBA).LIBOR is a forward-looking rate (from overnight to twelve-months out). It is also an unsecured rate, since no collateral is pledged against interbank loans.
Who Uses Libor?
Lenders, including banks and other financial institutions, have used LIBOR as the benchmark reference for determining interest rates for various debt instruments, including mortgages, corporate loans, government bonds, credit cards, and student loans. Apart from debt instruments, LIBOR has also been used for other financial products like derivatives. including interest rate swaps or currency swaps.Though the LIBOR will no longer be used for loans in the U.S., it hasn’t disappeared yet and will continue to be published until some time in 2023. Some loans may hang on to it as their benchmark until that time.
How LIBOR Affects Loans
All interest rates reflect market conditions to some degree. If you have an adjustable rate mortgage (ARM), your bank may have used USD LIBOR rates in the past to determine your future rate. While LIBOR was the most used benchmark rate for a time, it’s also possible your lender used a different model (to find out which, refer to your loan terms). While a benchmark like LIBOR affects the interest rate of loans, it’s never the only criteria. When you apply for a business loan, for example, your rate is also influenced by things like your:
Based on what the most prominent banks are lending at
Determined by a relatively small group of banks based on their own judgment
Forward looking – rates can be given out a year in advance
Rates can easily be manipulated by banks
Multiple currency options (USD, GBP, EUR, JPY, and CHF)
Contributed to the 2008 financial crisis
The History of LIBOR
LIBOR can be traced back to 1969, when a Greek banker named Minos Zombankakis helped arrange a loan to the Shah of Iran based on the reported funding costs of a set of reference banks. However, it didn’t formally enter the scene until it was introduced in 1986 by the British Bankers Association as a way to bring accuracy and reliability in calculating interest rates. It soon became the default standard interest rate between banks in both the U.K. and abroad.
2008 Financial Crisis
Just prior to 2008, a variety of risky mortgages and other financial products were insured by financial companies using credit default swaps, or CDSs (which enabled one investor to swap their credit risk with another). CDS rates were set by LIBOR. American International Group (AIG) was one of the largest issuers of CDSs on subprime mortgages, and when the company failed, the effects rippled out across the financial system. LIBOR spread the crisis far and wide since every day LIBOR-setting banks estimated higher and higher interest rates. LIBOR rose, making loans more expensive despite the efforts of central banks to lower interest rates.Thus LIBOR became one of the driving forces of the financial crash.
LIBOR Scandal of Rate Rigging
In 2012, investigations into the way LIBOR was set uncovered a long-term scheme among several large banks to manipulate LIBOR for profit.For example, when Barclays would submit its LIBOR estimates, it would claim that the rate was lower than what other banks actually charged the bank. A lower rate benefits a bank because it indicates less risk of default, so doing this made Barclays look like it was in better shape than other banks with a higher rate.In another example, a trader at UBS named Thomas Hayes colluded with multiple banks in a huge rate rigging scandal that led to hundreds of millions of dollars in profit for UBS. He was sentenced to 11 years in prison, but ultimately only ended up serving five years. The 2012 investigations also uncovered that Deutsche Bank, Royal Bank of Scotland, and Rabobank all lied about their LIBOR rates to their advantage.
Phasing Out
The scandals, along with the fact that banks have been changing the way they transact business, has undercut LIBOR and made it a less reliable benchmark. Finding a suitable alternative took time, but the U.S. has turned to the Secured Overnight Financing Rate, or SOFR. Switching won’t be without a few bumps, however. For starters, there still isn’t a way for lenders to look forward with rates using SOFR as the rate benchmark. With LIBOR, lenders could look at multiple timeframes. With SFOR, they can only look backwards. There also isn’t as much liquidity with the SOFR market as there was with LIBOR. However, as more and more lenders start to use SOFR, this should change as the market adapts to a new system. Lastly, there are still trillions of dollars in unpaid LIBOR-based loans.
Alternatives to LIBOR
Fortunately, there are many LIBOR alternatives, including the U.S.-backed SOFR. Here are some of the more popular options.
EURIBOR
Euribor stands for Euro Interbank Offered Rate. Like other rates, it takes the average rates at which banks are trading with one another (removing the top and bottom most extreme rates) to establish a benchmark rate. EURIBOR is currently used by the European money market, and, like LIBOR, EURIBOR rates are able to go up to 12 months.
TIBOR
The Tokyo Interbank Offered Rate, or TIBOR, is the daily reference rate derived from interest rates that banks charge to lend funds to other banks in the Japanese interbank market. Like LIBOR, rates go up to 12 month maturities, and are published every morning.
SHIBOR
The Shanghai Interbank Offered Rate, or SHIBOR, is a daily reference for Chinese banks, but some international banks have also adopted it. It’s modeled after LIBOR, but is more transparent than its predecessor since it publishes all of the data it receives.
MIBOR
MIBOR, which stands for the Mumbai Interbank Offered Rate, is the overnight lending offered rate for Indian commercial banks. Modeled after LIBOR, MIBOR is calculated based on input from a panel of 30 banks and primary dealers.
Prime Rate
The U.S. prime rate is the interest rate that commercial banks charge their most creditworthy corporate customers. The rates for mortgages, small business loans, and personal loans are based on the prime rate. Two key differences between the prime rate vs. LIBOR is that prime interest rates are tied to the U.S. Federal Funds Rate, and, though variable, the prime rate may remain fixed for a long period of time. Recommended: What Is the Federal Discount Rate?
SOFR
The secured overnight financing rate, or SOFR, is based on the rates U.S. financial institutions pay each other for overnight loans. These transactions take the form of Treasury bond repurchase agreements, called repos. Repos allow banks to meet liquidity and reserve requirements using Treasuries as collateral. SOFR comprises the weighted averages of the rates charged in these repo transactions. The benefit of SOFR is that it is actually established by real loans that have been disbursed. Because of this, it won’t be manipulated as easily as LIBOR was.
The Takeaway
For decades, LIBOR was a key benchmark for setting the interest rates charged on adjustable-rate loans, mortgages, and corporate debt. Because of numerous vulnerabilities and its connection to the 2008 financial crisis, it is being phased out by many countries for safer alternatives. In the U.S., it will be replaced with SOFR.For most borrowers, the transition shouldn’t be noticeable. New loans are already using the SOFR benchmark to determine interest, and the benchmark rate is actually only one of many factors that go into determining what interest rate you will pay. For example, if you’re applying for a small business loan, such as an SBA loan, lenders will also look at your credit scores, time in business, annual revenue, and collateral when determining your rate. If you’re interested in comparing small business loan rates, Lantern by SoFi can help. With our easy online lending tool, you can immediately get offers from multiple small business lenders with just one application and without making any type of commitment.
Frequently Asked Questions
What does the acronym LIBOR stand for?
Why is LIBOR being replaced?
What is the equivalent of LIBOR in the U.S.?
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About the Author
Lauren Ward
Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
