Mortgage Watch: Why Libor May Cost You Money

AP

Most homeowners probably don't know what it is--or even how to pronounce it. But the London Interbank Offered Rate, or Libor, is having a noticeable impact on adjustable-rate mortgages.

The reason: It's rising--and fast. Thie week, the three-month Libor rate for dollar-denominated loans hit 5.72%, the highest level in over six years.

The increase is also making it harder for big acquisitions to get completed and hurting the ability of companies to get short-term financing for ongoing operations.

With that in mind, here's a look at what's going on with Libor and why you should care about it.

What is Libor?

Libor (pronounced LIE-bore) is the interest rate global banks charge each other for short-term loans outside of the U.S. It's also used as a benchmark to calculate everything from adjustable-rate mortgages to what companies pay for short-term borrowing in the credit markets. It's similar to the federal funds rate in the U.S., an overnight bank rate set by the Federal Reserve, in that it affects a lot of other interest rates.

Why did Libor go up so much?

More banks are reluctant to lend money to each other because of worries about subprime mortgage exposure and other credit problems. So banks are forced to pay a higher interest rate to borrow money.

Short-term cash is also harder to come by because of the near freeze-up of the asset-backed commercial paper market, where companies borrow money. As with any case of supply and demand, a shortage of available cash means it'll cost you more to borrow it. So interest rates go up.

How does this affect homeowners?

Libor is among the most common benchmarks used to set adjustable-rate mortgages. Anyone whose adjustable rate is being reset now could end up paying a half point more than just a month ago.

On a 30-year loan of $400,000, that could translate into an additional $47,000 over the life of a loan.

"That's still small potatoes compared to the Libor's runup in 2004," according to Greg McBride, senior financial analyst for BankRate.com. Still, McBride says the rise in short-term interest rates over the past three years has driven homebuyers to fixed-rate mortgages.

"A 30-year fixed-rate mortgage has a rate of about 6.5%, while a five-year adjustable rate is up to 6.45%," McBride adds. As rates like Libor rise, "homebuyers are finding the value is in fixed rate loans."

What about corporate mergers?

A lot of mergers and corporate buyouts are financed by debt. And the interest rate on those borrowings is often tied to Libor. That means it'll cost more to complete a merger, which these days means it could be delayed or even canceled. Other pending leveraged buyouts, totaling over $200 billion, could become more difficult to fund if higher Libor rates persist.

Will Libor affect what the Fed does about interest rates?

Given the Libor's status as a global benchmark, its rise broadly pushes up borrowing costs. That complicates matters for the Fed as it tries to ease the current credit crunch without having to cut the fed funds rate.

"We are seeing volatility returning in the short-term credit markets. This is likely to pressure the Fed to continue to cut," says Andrew Bekoff, chief investment strategist at Printz Capital Management. "The market is now pricing in a 25 basis point cut in the discount rate Sept. 18. If this pressure continues we could see 50 basis points."