LIBOR Loans are some of the newest products available in the market. In years past, most ARMs were tied into one of the Treasury Indexes, commonly the Monthly Treasury Index or 1 year T Bill. The problem was that these indexes are influenced by the moves of the Federal Reserve. In periods where inflation was seen in the economy, the FED would move to increase short term borrowing costs which would adversely affect the T Bill. Lenders are migrating from a T Bill based product to LIBOR Loans because the index has proven to be more stable and frequently offers a lower margin.
The LIBOR Loans index is defined as the base rate paid on deposits between banks in the Eurodollar market. The LIBOR rates quoted in the Wall Street Journal is actually the average of rate quotes from five major banks. Please be aware that there are several different versions of the LIBOR indexes which can be very confusing when evaluating LIBOR Loans. The Journal quotes a 1 month, 3 month, 6 month, and 1 year LIBOR index so be very sure which index your proposed index is tied to.
In general, LIBOR Loans offer the lowest rate and payment option in today's market. These products can be very straight forward as is seen in the information below or can be a very sophisticated financial tool as is the case with the Cash Flow Libor Loans. One of their best features is that they can easily be set up with an interest only libor loans option which can reduce your monthly carrying cost substantially. Reduced documentation libor loans are readily available as well
A very important concept to understand is the yield spread curve. This is a chart graphing the differences between long term borrowing costs (traditional fixed rate mortgages) and short term borrowing costs (LIBOR indexes) Consider how steep the curve is when fixed rate mortgages are at 6% and the 1 month LIBOR index is at 2% as is the case at the time of this writing. This is how lenders have traditionally made money. By selecting a fixed rate loan, you are clearly borrowing at the long end and by selecting LIBOR loans, you are borrowing at the short end. Interest rates will change. However, we can manage risk by selecting the appropriate loan with a fixed period that matches your situation. If you anticipate an increase in income in a relatively short period, select a shorter fixed period. Lets look at the math.
In the 3 years my client planned to keep the home, the fixed rate would have cost him $22,000 more!
Lets look at how to evaluate these products and try to give you a real basis of comparing specific loans. There are 3 components involved in the selection process. Index, margin, and your situation. I like to start with your situation to select the appropriate fixed period, determine which index, and then look at all of my lender's margins to determine which is the lowest. Remember, the index will change but your margin is fixed.
These products are available with fixed periods ranging from 1 month to 10 years. A conservative approach will lead us to select a longer fixed period but you may want to consider the very short end as well as these loans can offer very small margins on a low and slow moving index. I have included a chart comparing the LIBOR loan index to several other indexes that may be useful.
Read more about Libor Loans Closing Costs
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