What do the terms Libor, federal funds or the U.S. prime rate
have to do with you? Well, if you hold any type of loan, such as a
credit card or a mortgage, these interest rate benchmarks can make
a big difference to your bottom line.
"It directly affects your pocketbook," says Rebel Cole, a
professor of finance at DePaul University. For example, if you
carry a balance on a variable rate credit card, the amount you have
to pay each month is partially determined by the U.S. prime rate.
That rate, in turn, is influenced by the federal funds rate, which
the Federal Reserve sets during each of its Federal Open Market
Committee meetings.
"These rates may seem obscure, but they have an actual impact,"
says Michael Tucker, a professor of finance at Fairfield
University. Not just on you, but also your employer, your city and
local businesses.
For example, a small business's ability to expand its operations
may be determined, in part, by its ability to borrow what it needs
to do so without paying sky-high rates. A bank's ability to freely
lend to that small business, in turn, is partially determined by
its ability to borrow overnight funds at an affordable rate.
Nearly every U.S. consumer is affected in some way by the the
federal funds rate, the U.S. prime rate or by Libor. However,
exactly how they're affected -- and how these rates work -- is less
than clear.
If you, too, are confused, here's a basic primer on what you
need to know about three of the world's most important benchmark
interest rates.
U.S. prime rate
What it is
The U.S. prime rate is an interest rate benchmark based on the
rates that banks charge their best customers. That usually means
big businesses, says Fairfield University's Michael Tucker. "It's
unlikely to be individuals, unless they're extremely wealthy."
How it affects you
Each bank sets its own prime rate, which is the bank's gold
standard interest rate, against which all other interest rates
based on the prime rate are set. Customers with the best ability to
repay a big loan are charged interest based on the prime rate, or
in rare cases, below the prime rate. All other customers, such as
credit card holders, are charged the prime rate, plus additional
percentage points, usually based on the customer's
creditworthiness.
So if you've got a variable rate credit card with a 9.99 percent
APR, a fraction of that APR is determined by whatever the issuing
bank's prime rate is at the time.
Typically, the U.S. prime rate is 3 percentage points above the
federal funds rate. However, "there's no guaranteed relationship,"
says Daniel Seiver, a professor of finance at San Diego State
University. A bank isn't obligated to tie its prime rate to the
federal funds rate.
How is it set?
The Wall Street Journal calculates and publishes the U.S. prime
rate -- which is currently set at 3.25 percent -- by surveying 10
of the largest banks in the country and asking what rates are being
charged to their best corporate customers. The paper publishes the
U.S. prime rate daily, but it doesn't recalculate the rate until a
certain percentage of banks say they've changed their rate. If at
least 70 percent of the banks report that they have begun charging
a different prime rate, then the Wall Street Journal recalculates a
new base rate.
Generally, banks are slow to change their prime rate. If
borrowing becomes costlier for a bank, then a bank will consider
raising its prime rate so that lending remains profitable. "If it
costs me more money to raise the money, then I have to charge you
more for that loan," explains Bob Mark, founder and CEO of the
consulting firm Black Diamond Risk. Mark used to play a key role in
setting the prime rate for a Canadian bank and the system there is
very similar, he says.
If a bank's lending costs go down, on the other hand, "they're
likely to pass that savings on to you, the borrower," says DePaul
University's Rebel Cole.
A bank also needs to independently consider what banks it
competes with may do before the bank decides to announce a new
prime rate to the market, says Mark. "The decision calls for
applying a little game theory in terms of who goes first and do
other people follow," he says. For example, "you don't want to be
the first one to announce that you are raising the prime rate and
you subsequently lose market share since no other bank ultimately
follows."
Generally, most banks tie their prime rate to the federal funds
rate and wait for other banks to move before they make any changes.
"All banks tend to change their prime rate around the same time and
at the same level," says San Diego State University's Daniel
Seiver.
Banks' tendency to move in lock-step with one another is
partially why the U.S. prime rate has remained so stable. The U.S.
federal funds rate hasn't moved since 2008 and neither has the U.S.
prime rate.
Federal funds rate
What it is
"The federal funds rate is the rate at which banks borrow from each
other on an overnight basis," says DePaul University's Rebel Cole.
It's the amount of interest banks pay in order to borrow fast
cash.
Banks often borrow from one another overnight in order to keep
the amount of money they have available at a certain, federally
mandated level and make sure they have enough cash on hand for
other needs. If a bank needs money quickly, the bank can get it by
tapping another bank's balances, which are held at the Federal
Reserve. "It's the way they can fund themselves in the very short
term," says Cole.
How it affects you
Many variable rate loans in the U.S., such as credit cards, are
based on the U.S. prime rate. The prime rate, in turn, is
typically 3 percentage points above the federal funds rate. So when
the federal funds rate is changed, the annual percentage rates
(APRs) of variable rate loans tend to immediately go up or down as
well.
How it is set?
The actual federal funds rate is set by the open market as banks
loan each other money from day to day.
The federal funds rate "target," on the other hand, is set by
the Federal Open Market Committee (FOMC), which is headed by
Federal Reserve Chairman Ben Bernanke. Generally, when commentators
refer to the federal funds rate, they're usually referring to the
target rate set by the Fed, rather than to the actual federal funds
rate.
The FOMC meets every few months and decides whether to raise the
federal funds rate target, lower it or keep it as is.
The target rate is used as a tool to help control the nation's
money supply and promote employment. For example, if inflation
begins to run above the Federal Reserve's target rate, the Fed may
choose to raise the federal funds rate target. By doing so, the Fed
is restricting the amount of money that's available to banks,
making it more likely that they'll raise interest rates on
commercial and consumer loans. That, in turn, should help control
the prices of goods and services by dampening commercial activity.
Meanwhile, if the U.S. economy is sputtering and unemployment is
high, the Fed may choose to lower the federal funds rate target in
order to help bring borrowing costs down and encourage businesses
and consumers to spend.
That's what the Federal Reserve did in 2008 when the economy
headed into a tailspin. As banks clamped down on lending, the
Federal Reserve pushed the federal funds rate target down to
rock-bottom -- between 0 percent and 0.25 percent. The target rate
hasn't moved since, and FOMC members say they're unlikely to move
it until at least late 2014.
Libor
What it is
"That's the bank rate that banks loan money to each other," says
Fairfield University's Tucker. Unlike the federal funds rate, which
only applies to U.S. banks, the London Interbank Offered Rate (or
Libor) is a London-based international interest rate benchmark used
around the globe.
Often referred to as the world's most important short-term
interest rate, Libor is used as a benchmark for a wide variety of
loans in the U.S. and abroad. "Fewer and fewer loans are tied
to the prime rate," says Cole. "More and more are tied to Libor or
to treasuries."
How it affects you
Most U.S. credit cards are based on the prime rate. However, a
large number of other consumer loans, such as mortgages, tend to be
based on Libor. "A lot of American households could have mortgage
loans that are variable and they are tied to Libor," says San Diego
State University's Seiver. "I have a mortgage myself that adjusts
every year. If you have an adjustable rate mortgage, then [Libor]
could very well determine your mortgage."
In fact, according to a 2009 study by the Federal Reserve Bank
of Cleveland, nearly 60 percent of prime U.S. mortgages in the
state of Ohio were tied to Libor in 2008 and nearly all subprime
mortgages were tied to Libor.
Other consumer loans tied to Libor may include private student
loans and auto loans. To check which interest rate your loan is
pegged to, look through your loan documents and check for wording
that mentions either the London Interbank Offered Rate or the prime
rate. If you find that you have a loan that is based on Libor, also
check what type of Libor rate it is. Commentators often refer to
Libor as just one rate. However, there are multiple types of Libor
rates, including a 1-month Libor rate, a 3-month Libor rate, a
6-month Libor rate and a 1-year Libor rate.
How is it set?
A sample of 18 banks, including Barclays, Chase, Citi, HSBC and
Bank of America, report to the British Bankers' Association how
much interest they expect to be charged by other banks for a
short-term loan. Banks' interest rate estimates aren't required to
be based on actual transactions. However, the banks are expected to
give their best guesses.
The news and information service Thomson Reuters then takes that
information, throws out the four largest reported rates and the
four smallest reported rates, which it says are outliers, and
averages the 10 rates in the middle. It then publishes the
new information each morning on behalf of the British Bankers'
Association.
Not all banks have been following the rules, however. As of
press time, at least one major bank, Barclays, admitted to falsely
reporting a different rate than the bank expected to be charged and
a number of other banks are under investigation for doing the same.
Bankers' reasons for manipulating the Libor rate varied, according
to numerous press reports. In some cases, banks directly profited
from the manipulated rates. In other cases, rates were manipulated
in order to make a bank look healthier than it actually was.
The revelation that rates were rigged sent shock waves through
the financial system as regulators considered legal action and
consumers came to terms with the fact that the interest rates on
their loans may have been based on made-up figures.
"The major problem here is that people believed that the rates
that were being reported were the actual lending rates," says
Fairfield University's Tucker. "If it turns out there was collusion
and these were not the rates, then the whole system is
suspect."
The impact on consumers is relatively small, say experts. "The
cheating that's gone on is so small that really it is not material
to a borrower on their loan," says DePaul University's Cole.
However, those tiny changes "can be hugely profitable to a bank
that has trades that are tied to the Libor rate," he says.
The small differences in rates can also profoundly affect other
big borrowers, such as U.S. cities, which borrow huge amounts and
so are more vulnerable to small changes.
As of press time, regulators at the Bank of England have
announced plans to reform the Libor-setting process and are
currently taking steps to make it less susceptible to
manipulation.
The bottom line:
These rates matter. Benchmark interest rates, such as the prime
rate, may be slow to move. However, when they do, they can make a
big difference to how much you'll pay on the life of your loan.
So if you've got a variable rate loan, the best thing you can do
for your wallet is to pay close attention to the rates your loans
are based on, say experts. Be prepared for sudden rate increases
and know before you sign up for a brand-new loan that your expected
payments could change significantly in the future.
See related:
As expected, Fed keeps rates at rock bottom.