If your adjustable-rate mortgage is linked to LIBOR, brace yourself
— -- The London Interbank Offered Rate, or LIBOR, sounds like one of those funny British idiosyncrasies, like warm beer or the royal family. But if you have an adjustable-rate mortgage or a student loan tied to the LIBOR, you will not be amused by what's been happening to this index in recent weeks.
LIBOR is the interest rate large banks charge each other for short-term unsecured loans. About half of adjustable-rate mortgages, and nearly all subprime mortgages, are pegged to the LIBOR, usually plus a margin of several percentage points. Last week, the six-month LIBOR was 4.13%, vs. 2.99% at the end of April, according to Bankrate.com. In the past few days, the index has been edging lower, falling to 3.83% on Monday, according to Bloomberg.com. Nevertheless, the LIBOR is still a full percentage point higher than it was in May.
If you have a one-year ARM that's scheduled to reset within the next few weeks, it may well be tied to LIBOR. And if that's the case, brace yourself. Borrowers who have been paying 5% on their ARMs for the last six months could see their rate rise to about 6.5%, says Greg McBride, senior analyst for Bankrate.com.
For prime borrowers whose mortgages reset six months ago, that could mean a big jump. The payment on a $250,000, 30-year loan with a 5% rate is $1,342 a month. At 6.5%, the payment jumps to $1,580 a month. Subprime borrowers, who pay a higher margin over the index, could see their rate jump as high as 9%.
An Oct. 6 report by Citigroup Global Markets predicts that the LIBOR increase could boost subprime defaults by 10%. The report estimates that 121,590 securitized ARMs will reset next month.
"We could see another wave of homeowner distress if LIBOR-index borrowers begin to see sharp payment increases," McBride says.
Monday's decline in the LIBOR reflected expectations that government intervention will stabilize the banking system. Many one-year ARMs are reset every six months, so if the downward trend continues, the rate increase will be temporary, says Keith Gumbinger, vice president for HSH Associates, which publishes information about mortgages and consumer loans.
That's a good thing, because most ARM borrowers will have no choice but to make the higher payments, Gumbinger says.
Refinancing to a fixed-rate mortgage probably won't lower your interest rate, Gumbinger notes. Last week, the average rate for a 30-year, fixed-rate mortgage jumped to 6.46% from 5.94% a week earlier, the biggest weekly jump since 1987, according to mortgage giant Freddie Mac.
The rate increase reflected concerns that the government's $700 billion financial rescue plan could ignite inflation and put pressure on long-term rates.
Some economists believe fixed-rate mortgages will fall once fears about the outlook for the economy recede. But even if that happens, borrowers will have a hard time finding a lender willing to refinance their loan, says Stephen Thode, director of the Goodman Center for Real Estate Studies at Lehigh University.
"The reality is that lenders don't think we've hit bottom, and they're reluctant to lend into a declining market," Thode says.
Not all ARM borrowers are crying in their beer. Borrowers whose ARMs are linked to U.S. Treasury securities could see their rates go down in the next few weeks. U.S. Treasury securities are a common benchmark for hybrid ARMs that have a fixed rate for a few years, then adjust annually.
Nervous investors have piled money in U.S. Treasury securities in recent weeks, driving yields on those securities down at the same time the LIBOR was rising, McBride says. If your ARM is pegged to one-year Treasury bills, he says, your rate could drop as low as 4% for the next year.
That doesn't necessarily mean that Treasury-linked ARMs are always a better deal, Gumbinger says. Sometimes, borrowers with mortgages tied to LIBOR end up with lower rates, he says.
The bottom line: If you can't handle an increase in your monthly mortgage payment, stay away from adjustable-rate mortgages.
Higher student loan rates
The increase in the LIBOR could also boost monthly payments for borrowers with private student loans, says Mark Kantrowitz, founder of FinAid, a financial aid website. About half of those loans are pegged to the LIBOR, he says.
Some of the largest private lenders reset their rates monthly, and borrowers with those loans will feel the greatest impact of the run-up in the LIBOR, he says. Based on recent LIBOR rates, Kantrowitz estimates that private-loan borrowers will see their rates rise from an average of 10%-11% to 13%-14%.
The interest rate jump points up the importance of taking full advantage of fixed-rate federal student loans before venturing into the private-loan market, he says. Federal student loans, which have a fixed rate of 6.8%, "are cheaper, and you're not going to be on this roller coaster."
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