The LIBOR Transition and How It Impacts You

With LIBOR set to be retired over the course of the next few years, it’s important to understand how its sunset might impact any loans you have as well as your overall banking experience.

Consider this your primer on LIBOR, arguably the most important financial acronym you’ve (perhaps) never heard of.

What is LIBOR?

The London Interbank Offered Rate — commonly known as LIBOR — is an index used by major global banks to determine the interest rate they would charge other banks for a short-term loan. LIBOR is based on five international currencies (U.S. dollar, euro, British pound, Japanese yen, Swiss franc) and is set daily for seven different term lengths, ranging from overnight to one year.

Financial institutions reference LIBOR when setting interest rates for a variety of products, including adjustable-rate mortgages (ARMs), credit card accounts, and student loans. When a loan rate moves up or down, a change in LIBOR is partially responsible.

How LIBOR is Calculated

Each morning, the Intercontinental Exchange Benchmark Administration (IBA), which oversees LIBOR, asks a panel of 16 international banks how much interest each one would charge other banks for short-term loans. The participating banks are required to submit rates using their country's currency for seven loan maturity periods:

• Overnight 
• One week
• One month
• Two months
• Three months
• Six months
• 12 months

After the IBA receives the estimates, administrators calculate LIBOR rates using the Waterfall Methodology, a standardized, transaction-based model that was implemented in 2019. All 35 LIBOR benchmarks are then published just before noon London time.

How LIBOR Affects Loans

Lenders around the world use LIBOR as a "reference rate" to gauge where interest rates are going and as a predictor of future loan costs. That means when you apply for a LIBOR-based loan, your lender uses one of the LIBOR rates and then adds an extra percentage to determine the interest rate you'll pay.

For example, suppose you have a private student loan that's based on the LIBOR three-month rate plus 2%. If the LIBOR three-month rate is 0.22%, the base interest rate for your loan would be 2.22%.

Similarly, if you have an ARM that references a LIBOR rate, the interest rate you pay — and by extension, your monthly mortgage — will reset either higher or lower based on the LIBOR rate. The same thing happens with any outstanding monthly debt you carry on LIBOR-referencing credit cards, student loans, or other variable-rate financial products.

Why LIBOR is Being Transitioned

LIBOR, which traces its roots to the late 1960s and Greek banker Minos Zombanakis, has been in widespread use since 1986. Today, it's estimated that more than $10 trillion worth of loans worldwide are impacted by the LIBOR rate. In the United States alone, LIBOR affects roughly $1.2 trillion in ARMs.

Despite its history and decades of international applications, LIBOR has begun being phased out and is expected to be completely discontinued after its final publication on June 30, 2023.

As part of this transition, the one-week and two-month LIBOR rates for the U.S. dollar will no longer be published after Dec. 31, 2021. Many financial institutions have already stopped writing loans that reference any LIBOR rate.

The termination of LIBOR can be attributed to several factors, not the least of which is rate manipulation by several major financial institutions. In fact, the fraudulent reporting and rate deception linked to LIBOR played a role in worsening the 2008 financial crisis that rocked economies worldwide.

Following the 2008 recession and revelations of LIBOR rate manipulation that came to light several years later, LIBOR lost some of its credibility. This, coupled with a dramatic slowdown in the number of loans between banks and too few transactions in some currencies, made it more difficult to provide accurate and trustworthy estimates of LIBOR.

The Future of LIBOR and Rate Determination

In 2014, the U.S. Federal Reserve created the Alternative Reference Rate Committee (ARRC) and tasked the group with identifying a benchmark interest rate to replace LIBOR for the U.S. dollar. The ARRC ultimately recommended the Secured Overnight Financing Rate (SOFR), an index that is based on data from actual transactions rather than on estimated borrowing rates as with LIBOR.

On Nov. 30, 2020, the Federal Reserve instructed financial institutions to stop writing new loans that reference LIBOR by the end of 2021. The agency also mandated all current contracts that use LIBOR should be transitioned to a new reference rate by June 30, 2023.

It's important to note that SOFR has not been named as the official replacement for LIBOR, although it's widely believed that SOFR will eventually become the dominant benchmark.

That said, many credit unions and banks have already begun referencing select SOFR rates in some of their contract language. In other cases, lenders are using additional non-LIBOR indexes as the benchmarks for setting their interest rates.

How This Impacts You

If you currently have a loan that references LIBOR, your lender can technically continue using this index to adjust interest rates through June 30, 2023. In this situation, your loan would adhere to the terms outlined in your original contract.

After June 30, 2023, no loans will be allowed to reference LIBOR. Your lender will be required to use a new index, whether it's SOFR or another rate indicator. Ideally, your lender will make every effort to select a replacement index that minimizes any change in the cost of your loan.

What You Should Do

If you currently have a LIBOR-referencing loan, there are several things you can do as the financial industry fully transitions to a new interest rate index. You can choose to:

Do Nothing

If you have a LIBOR-referencing loan that's scheduled to mature before June 30, 2023, you can simply do nothing and continue to pay the loan under its current terms.

Pay Off Your Current Loan

Next to doing nothing, paying off your current loan (if you can afford to) is the easiest way to navigate the move away from LIBOR.

Refinance Your Loan

You can refinance your LIBOR-referencing loan prior to the index's discontinuation and select a fixed-rate loan or another variable-rate product that's tied to a non-LIBOR index.

Transition to a New Index

If you have a LIBOR-referencing loan that matures after June 2023, you can also opt to do nothing and stay in the loan. In this case, you'd continue to pay the loan under its current terms and then under the new index chosen by your lender when LIBOR is discontinued.

Even if you don't have a LIBOR-referencing loan, it's a good idea to visit your credit union or bank's website periodically for updates. Also be on the lookout for advance notices from your lender(s) about LIBOR's discontinuation and how it might impact you.

An Acronym for a New Era

Truth is, moving on from any type of relationship brings with it a variety of challenges and opportunities.

So as the financial industry transitions from its longstanding affiliation with LIBOR, familiarize yourself with its history and the role it and other interest rate indexes play in lending.

That way you'll be prepared for the acronym of a new era, whether it be SOFR or some other yet-to-be-assigned abbreviation.