Summer School: LIBOR

Financial summer school

TEXT OF STORY

Tess Vigeland: That's right -- Marketplace Money Summer School is back in session.

We're defining some of most confusing financial terms out there so you can dazzle your friends at the next summer barbecue.

First up: LIBOR -- that's L-I-B-O-R, all in caps.

At the blackboard this week is Jonathan Clements.


Jonathan Clements: LIBOR, otherwise known as the London Interbank Offered Rate, might seem like one of those obscure foreign financial things that Americans really don't need to worry about, but in fact, what's happening with LIBOR may be affecting the cost of your student loan, the return on your mutual fund and the interest rate on your mortgage.

LIBOR, which is calculated each morning in London by the British Bankers' Association, reflects the average rate at which major international banks lend to one another. That rate in turn is used to calculate the rate on a slew of other financial instruments.

Let's say you have an adjustable rate mortgage. Dig into the fine print and you might discover that the mortgage is repriced each year at, say, 2.5 points over 1 year LIBOR. If LIBOR is at 3.5 percent, you're looking at paying 6.

LIBOR has existed for years and years, but in terms of its effect on American financial life, it's really ballooned over the last 10 years as more and more financial instruments get pegged to what's going on in the London financial markets. If the rate on LIBOR shoots up, Americans who have adjustable rate mortgages that are tied to LIBOR are going to feel the pain, but there's a limit to how much damage can be done. With an adjustable rate mortgage, there's usually a cap on how much the rate can increase from one period to the next. So even if LIBOR goes through the roof, an American homeowner might only see their mortgage go up by the cap, which might be just two points for any one year.


Vigeland: Jonathan Clements is the director of financial guidance for MyFi, an advisory service from Citigroup.

Next week: dollar cost averaging.

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