A big change that could affect nearly every borrower in the country recently took place, and you probably didn’t even realize it.
As of April 9th, the long-standing London Interbank Offered Rate (Libor), a reference rate used to help set other interest rates, will start being phased out, to be replaced by a newly created rate called the Secured Overnight Financing Rate (SOFR).
Translation: Because Libor is the most commonly used benchmark in setting short-term interest rates, this change could impact the interest you pay on an adjustable-rate mortgage, home equity line of credit, private student loan, credit card, car loan or business loan, among other types of lending.
WHY THE SWITCH?
Libor was created in 1986 by the British Bankers’ Association as a way to measure and track the interest rates banks pay when they borrow from each other. Lenders quickly embraced Libor, and it soon became a critical pricing benchmark for trillions of dollars of loans and other financial instruments around the globe.
Soon dubbed “the world’s most important number,” Libor seemed ripe for manipulation right from the start. That’s because Libor, unlike other benchmarks, isn’t based on actual borrowing costs. Instead, it’s calculated from the results of a daily survey that asks banks to provide an estimate of what it would cost to borrow from each other on an unsecured basis (meaning without any collateral, like a piece of property, backing the debt).
In 2012, government investigations showed that several major banks had used their “best guess” estimate to rig Libor rates before and during the financial crisis for their own benefit. More than a dozen banks paid hefty fines related to this price manipulation, senior executives and traders lost their jobs, and Libor’s credibility was permanently tarnished.
Around the same time, changes to banking regulations were hurting demand for those interbank short-term loans that referenced Libor — another factor that decreased the relevance of this once all-important benchmark.
HOW DID SOFR COME ABOUT?
In 2014, the Federal Reserve tasked a special committee composed of bankers, financial professionals and regulators with the job of identifying a replacement to the U.S. dollar Libor, the Libor rate specifically tied to U.S. currency (there are multiple Libor rates based on various currencies and maturities). Last summer, the committee chose SOFR as its preferred alternative. So earlier this month, the Federal Reserve Bank of New York began publishing the daily SOFR rate.
SOFR addresses the vulnerabilities of Libor in two important ways. First, SOFR is based on actual lending rates between banks, helping to reduce the risk of manipulation. And second, the benchmark rate is based on short-term loans that use U.S. Treasurys as collateral, versus Libor loans, which had no collateral.
SO WHAT NOW?
While Libor rates are available in seven different maturities, ranging from overnight loans to those lasting one year, SOFR is currently an overnight rate only. For now, this somewhat limits SOFR’s broad use. Also, because SOFR is based on transactions secured by virtually risk-free U.S. Treasurys, it doesn’t “bake in” a premium for taking on risk. This means SOFR reference rates are likely to be lower than that of the U.S. dollar Libor.
The committee is still looking at ways to address these and other issues that may emerge as SOFR gains ground, but the plan to phase out the market’s dependence on Libor by 2021 continues to move along. In the meantime, Libor and SOFR are likely to co-exist for some time.
HOW DOES THIS ALL AFFECT ME?
If you have a fixed-rate loan or mortgage, the transition to SOFR won’t impact the interest rate you pay. However, if you have a variable-rate loan (think adjustable-rate mortgages or private student loans) or a variable-rate certificate of deposit, your interest rate could go up or down. The same would be true for other types of debt typically indexed to Libor, such as corporate business loans, commercial mortgages and variable-rate bonds. Some credit cards also tie their interest rates to Libor.
The good news is, you’ll receive a notice from your lender when they decide to switch the benchmark of any of your loans from Libor to SOFR. You can also check the fine print of any variable-rate loans you have to see if they are indexed to Libor — if they are, you’ll know to expect a change.