Definition
LIBOR, which stands for “London Interbank Offered Rate,” is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans. It serves as a global reference rate for such financial products as mortgages, loans, and financial derivatives. LIBOR rates are calculated for five currencies and several borrowing periods, ranging from overnight to one year.
Key Takeaways
- LIBOR, which stands for London Interbank Offered Rate, is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans. It serves as a reference point for debt instruments around the world.
- LIBOR is calculated and published each business day by the ICE Benchmark Administration. It covers five currencies (USD, EUR, GBP, JPY, and CHF) and seven different maturities, ranging from overnight to 12 months. The calculation of each LIBOR rate reflects the average interest one bank would expect to pay another in order to borrow money.
- As of 2021, UK regulators have planned to phase out LIBOR due to several manipulation scandals. Moving forward, it will be replaced by more transaction-based alternatives like the Secured Overnight Financing Rate (SOFR) in the US or the Sterling Overnight Interest Rate Average (SONIA) in the UK.
Importance
The London Interbank Offered Rate (LIBOR) is a significant financial term as it serves as a global benchmark for short-term interest rates.
Used by banks, mortgage companies and credit card agencies worldwide, it essentially indicates the interest rate at which these institutions lend funds to each other in the international interbank market for short-term loans.
Hence, it impacts how much consumers pay for loans, mortgages, or any other borrowing.
Moreover, LIBOR is extensively used as a reference rate for a lot of financial products and contracts, including complex derivatives and swaps, making it integral to the global financial system.
Therefore, even a slight fluctuation in LIBOR can have a broad impact on global markets and personal finances.
Explanation
The London Inter-bank Offered Rate, or LIBOR, is a benchmark interest rate used in financial markets globally as a reference point for a multitude of financial products. Its primary objective is to serve as a measure of the average rate at which banks are willing to lend to one another on the international interbank market for short-term loans.
As the most widely used reference rate in the global financial market, which reportedly underpins more than $350 trillion in derivative contracts worldwide, its importance cannot be overstated. LIBOR is used as a base for determining the interest rates for various financial products such as student loans, mortgages, credit cards, and complex derivatives and financial contracts worldwide.
Essentially, it operates as a significant indicator of the health of the financial system, reflecting the confidence or strive of banks to lend money to one another. When the LIBOR increases, borrowing costs for clients raise too, making it more expensive to get a loan.
Conversely, when the LIBOR decreases, the lower interest rates stimulate borrowing and hence, economic activity.
Examples of LIBOR
Adjustable-Rate Mortgages (ARM): These types of mortgages often depend on LIBOR for determining the interest rates. For instance, a homeowner may have an ARM that’s set to LIBOR plus 2%. So, if LIBOR is at 1%, their loan interest rate will be adjusted to 3%.
Business Loans: Companies may also have loans that are tied to LIBOR. A corporation may have a line of credit from a bank that comes with an interest rate set at LIBOR plus a certain percentage. As LIBOR rates fluctuate, so will the interest rates on those loans, influencing the borrowing costs of the corporation.
Student Loans: Some private student loan providers set their interest rates based on LIBOR. These rates are typically updated quarterly, meaning that a student’s loan payments could vary over time based on changes to the LIBOR rate. Thus a decrease in LIBOR may result in lower loan payments, while an increase in LIBOR may result in higher loan payments.
FAQs about LIBOR
What is LIBOR?
LIBOR, or the London Interbank Offered Rate, is the average interest rate at which major global banks borrow from one another in the international interbank market for short-term loans. It serves as a globally accepted key benchmark interest rate that indicates borrowing costs between banks.
How is LIBOR calculated?
LIBOR is calculated through a standardized, but complex, process. Every day, a panel of large, leading, globally active banks submit the interest rate at which they could borrow unsecured funds in the London interbank market for specific periods in various currencies. These submissions are processed by an authorized body, and the highest and lowest quartile of the rates are excluded to yield the average rate which is published as the LIBOR rate.
Why is LIBOR important?
LIBOR is important because it is a base rate in a vast range of financial products globally, including loans, mortgages, bonds, credit cards, and derivatives. Therefore, a change in the LIBOR rate influences the costs and profits in these financial products, indirectly impacting businesses, financial markets, and consumers.
What will replace LIBOR?
Due to a series of rate manipulation scandals, LIBOR is being phased out and expected to end by 2021. It will be replaced by several other rates, like the Secured Overnight Financing Rate (SOFR) in the U.S. and the Sterling Overnight Index Average (SONIA) in the U.K.
Related Entrepreneurship Terms
- Interest Rate Swaps
- Adjustable-Rate Mortgage
- Benchmark Rate
- Interbank Market
- Prime Rate
