What Is the LIBOR in Loans?

You might not realize the interest rates big British banks charge each other directly affects your debt payments, but that's what happens if you have a loan based on LIBOR. In the United States, LIBOR is most commonly used with adjustable-rate mortgages, but it also may be associated with other loans, such as credit cards.

LIBOR Defined

LIBOR is an acronym for the London Interbank Offered Rate and sometimes is written as Libor. LIBOR is a commonly referenced indicator of international economic conditions. Simply put, it's the average interest rate that major banks in London are offering one another for short-term loans denominated in U.S. dollars. The British Bankers Association compiles the LIBOR and updates it daily.

Loan Indexes

In the United States, LIBOR frequently is used as an "index" for variable-rate loans. These are loans in which the interest rate rises or falls based on the general direction of the credit markets, as opposed to a fixed-rate loan, in which the interest rate stays the same for the duration of the loan. The rate on a variable-rate loan typically consists of two elements: the index and the margin. The index is some underlying market-derived interest rate, such as LIBOR. The margin is an extra amount the lender places on top of the index. For example, a rate on a loan might be defined as "the six-month LIBOR plus 3 percentage points." In that case, the six-month LIBOR is the index, and the margin is 3 points. If the six-month LIBOR rate was, say, 3 percent, then the loan rate would be 6 percent. If the LIBOR went up to 4.3 percent, then the loan rate would become 7.3 percent.

Types

The British Bankers Association publishes four LIBOR rates, based on the length of interbank loans: one-month, three-month, six-month and one-year rates. According to Mortgage-X, which tracks indexes for mortgage loans, the six-month LIBOR is the most common LIBOR index. When taking out a loan based on LIBOR, you should make sure the loan documentation makes clear which index is to be used. Also make sure it says how you can find the index yourself. Many financial news outlets publish LIBOR numbers, and the figures published in "The Wall Street Journal" are often the "official" figures used by lenders.

Alternatives

LIBOR is just one possible index for variable-rate loans. Others include the federal funds rate; the rates on certain U.S. Treasury bills or certificates of deposit; the 11th District Cost of Savings Index, which reflects interest rates paid to depositors by savings institutions in three Western states; and the Wells Fargo Cost of Funds Index, which takes into account certain rates paid by that bank's subsidiaries. In general, an index should reflect overall economic conditions, but some are quicker to move than others or react more strongly to certain events.