The LIBOR, or the London Interbank Offered Rate, is used by many banks, lending institutions, and credit rating agencies to determine the interest rates charged for a variety of loans. In fact, the LIBOR is the world’s most widely used benchmark for short-term interest rates.
To understand how the LIBOR affects interest rates, it is first necessary to understand what the LIBOR is. This term is used to describe the interest rate at which banks offer short term loans to each other. In other words, the LIBOR is the average rate at which multi-national banks loan each other cash for periods of time between one and five days.
Since the LIBOR is the rate at which a large bank or lending institution borrows money, it is the minimum rate that they could charge on a loan to their customers and still break even. Therefore, the LIBOR is used as the base interest rate for a lot of loans to businesses and individuals. Depending on the type of loan, however, this calculation can be done in different ways.
The vast majority of variable interest rate loans will set their interest rates using a formula that looks very similar to LIBOR + a variable. This variable is either specified as a specific number of points in the loan terms or is specified as another formula, typically a specified rate + a specified number of points. Loans to people and business with good credit ratings usually just set the interest rate equal to LIBOR plus three to five points. As the credit risk of the client grows, however, banks will typically revert to the second formula. This means that the interest rate can be LIBOR plus three points plus market rate, where market rate can be defined by the lending institution.
Obviously, these loans carry a risk to the borrower, since the LIBOR rate fluctuates daily. This means that a loan with an adjustable interest rate can also fluctuate wildly. It should be kept in mind, however, that the LIBOR rate is considered to be one of the more stable benchmarks, and historically has not shown wild swings on a day to day basis. The recent upheaval in the credit market, however, has made this rate fluctuate more than usual.
For this reason many people and businesses prefer fixed rate loans. The interest rates for these loans are still dependent on the LIBOR, however. Lenders will usually look at a longer term average of the LIBOR, then add several points according to the credit worthiness of the borrower. Since the rate is fixed, lenders will tend to skew their numbers towards anticipating higher LIBOR rates, however, meaning that some people and businesses will pay more than if they had an adjustable rate loan.