When most Americans think of British imports, their minds probably conjure up images of James Bond and Monty Python movies. These are all fine contributions, and with the success of the aforementioned British imports, it's hard to argue their significance, but quite possibly the most important import from England has a direct impact on the wallets of many Americans, especially homeowners. In this article we'll explain a little understood yet extremely relevant financial tool used across the globe: the London Interbank Offered Rate (LIBOR).

What Is LIBOR?
LIBOR is equivalent to the federal funds rate, or the interest rate one bank charges another for a loan. The advent of LIBOR can be traced to 1984, when the British Bankers Association (BBA) sought to add proper trading terms to actively traded markets, such as foreign currency, forward rate agreements and interest rate swaps. LIBOR rates were first used in financial markets in 1986 after test runs were conducted in the previous two years. Today, LIBOR has reached such stature that the rate is published daily by the BBA at about 11:45am GMT.

LIBOR's reach is felt thousands of miles away from the Thames; it is used as the key point of reference for financial instruments, such as futures contracts, the U.S. dollar, interest rate swaps and variable rate mortgages. LIBOR takes on added significance in times of tight credit as foreign banks yearn for U.S. dollars. This scenario usually sends LIBOR for dollars soaring, which is generally a sign of imminent economic peril. (To learn more, see Top 5 Signs Of A Credit Crisis.)

The Reach of LIBOR
LIBOR is set by 16 international member banks and, by some estimates, places rates on a staggering $360 trillion of financial products across the globe. Included in those products are adjustable rate mortgages (ARMs). In periods of stable interest rates, LIBOR ARMs can be attractive options for homebuyers. These mortgages have no negative amortization and, in many cases, offer fair rates for prepayment. The typical ARM is indexed to the six-month LIBOR rate plus 2-3%. (For more, see This Arm Has Teeth.)

LIBOR's reach doesn't end with the homeowner. The rate is also used to calculate rates for small business loans, student loans and credit cards. More often than not, LIBOR's heavy hand isn't felt directly by homeowners or others in need of a loan. When the U.S. interest rate environment is stable and the economy flourishes, all is usually well with LIBOR. Unfortunately, there is another side to that coin. During times of economic uncertainty, especially in developed countries, LIBOR rates show signs of excessive volatility, making it harder for banks to make and receive loans among each other. That problem is passed down to people seeking loans from the bank. If cash is scarce or at a premium for your local bank, the bank simply charges you, the borrower, a higher interest rate, or worse, doesn't loan you the money at all.

If Times Are Bad, Watch LIBOR
Another prominent trait of LIBOR is that it can dilute the effects of Fed rate cuts. Most investors think it's great when the Fed cuts rates, or at least they welcome the news. If LIBOR rates are high, the Fed cuts look a lot like taking a vacation to Hawaii and getting rain every day. High LIBOR rates restrict people from getting loans, making a lower Fed discount rate a nonevent for the average person. If you have a subprime mortgage, you need to watch LIBOR rates with a close eye as almost $1 trillion in subprime ARMs are indexed to LIBOR. (For more information, read our Federal Reserve tutorial and to learn more about subprime mortgages, see Subprime Is Often Subpar.)

While LIBOR action in relation to the foreign exchange markets pertains more to currencies, such as the euro, the British pound, the Japanese yen, and others, its daily impact on the value of the dollars spent in the United States is negligible, though it is worth noting that LIBOR is very relevant to rates on the euro, or U.S. dollars held by foreign banks. The euro accounts for roughly 20% of total dollar reserves.

Bottom Line
LIBOR isn't sexy, and it's doubtful anyone is looking forward to the next release of LIBOR data with the same anticipation of seeing the next James Bond movie. That said, anyone with a credit card or a desire to own a home needs to be of aware of LIBOR. LIBOR is the true British monarchy, at least for the global financial markets - and your personal bottom line.

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: PowerShares Senior Loan

    Read an in-depth analysis of the PowerShares Senior Loan ETF, which is an innovative product tracking the US senior leveraged loan corner.
  2. Bonds & Fixed Income

    5 Signs Of A Credit Crisis

    These indicators can illuminate the depth and severity of problems in the credit markets.
  3. Savings

    Reduce Interest With An All-In-One Mortgage

    "Offset" mortgages combine a checking account, home-equity loan and mortgage into one account.
  4. Credit & Loans

    How Interest Rate Cuts Affect Consumers

    Traders rejoice when the Fed drops the rate, but is it good news for all? Find out here.
  5. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  6. Investing

    Latin America’s Economic Forecast

    After a ten-year run, the economies of Latin America are in a decline. For sustainable, long-term growth, the region needs structural reforms.
  7. Economics

    Why the Euro Failed to Become the World's Reserve Currency

    Examine the current state of the U.S. dollar as the world's reserve currency; learn the major reasons why the euro has failed to replace it in that capacity.
  8. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  9. Credit & Loans

    5 Credit Cards For the Super Rich

    Understand the difference between an average credit card and an elite credit card for the wealthy. Learn about the top five credit cards for the super rich.
  10. Economics

    These Will Be the World's Top Economies in 2020

    Discover the current economic forces that are anticipated to significantly shift the landscape of the world's most powerful economies over the next decade.
  1. How do I obtain a banker's acceptance?

    Banker's acceptances act like time drafts. They can be created as letters of credit, documentary drafts and other financial ... Read Full Answer >>
  2. Can individual investors profit from interest rate swaps?

    Interest rate swaps normally take place between two business entities, but individual investors can still use them to speculate ... Read Full Answer >>
  3. If interest rate swaps are based on two companies' different outlook on interest ...

    Interest rate swaps are, at their core, a derivative instrument built on the premise of comparative advantage. To see how ... Read Full Answer >>
  4. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  5. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  6. How can the federal reserve increase aggregate demand?

    The Federal Reserve can increase aggregate demand in indirect ways by lowering interest rates. Aggregate demand is a measure ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  2. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  3. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  4. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  5. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  6. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!