Why your adjustable interest rate mortgage isn’t helped by rate cuts
In a Bloomberg article about the ongoing credit crunch yesterday the news firm reports that the one-month LIBOR is at its highest point since the Federal Reserve rate cut in September. First the story, and then why it matters to you on main street with an adjustable rate mortgage.
From Bloomberg:
The London interbank offered rate that banks charge each other for euro loans due after the end of the year jumped 64 basis points to 4.81 percent, the highest since May 2001, the British Bankers’ Association said. The rate for dollars jumped 40 basis points to 5.23 percent, the highest since Sept. 18, when the Federal Reserve cut the target rate for overnight loans for the first time in 4 1/2 years.
Soaring bank lending rates reflect growing concern about the strength of financial institutions after more than $60 billion of writedowns this year linked to U.S. subprime-mortgage defaults. Losses may rise to $300 billion, according to the Organization for Economic Cooperation and Development.
“The increases we’ve seen in borrowing costs cannot be simply explained away by year-end pressures; this is a full-on credit crisis,” said Stuart Thomson, who helps oversee $46 billion in bonds at Resolution Investment Management Ltd. in Glasgow, Scotland. “There’s no end in sight either. It’s a really unpleasant picture.”
In simple terms this means that banks don’t trust each other enough to lender one another money because no one wants to get stuck holding the bag. If you lend a partner institution $20 billion and then suddenly that bank pulls a Northern Rock you could be a long way off from ever seeing any of that money again; and then you’re the one facing the cash crunch. So banks charge more in interest to protect themselves from that scenario and to be sure they’re adequately compensated for that risk. Makes sense, but wipes out the power of the Fed rate cuts for most Americans - here’s how.
If you have an adjustable rate mortgage (particularly those of the 2- and 3-year fixed variety) it is most likely based on some calculation of the LIBOR (click the link for the definition of LIBOR) usually between a 1-month average of the LIBOR (1-month LIBOR) and 6-month average of the LIBOR index (6-month LIBOR). These adjustable rate mortgages are calculated using the LIBOR as the index for the loan and then add a fixed margin to that number to get your fully indexed interest rate. Follow this link to learn how to calculate your fully indexed interest rate. While there are loans of all types and tied to indexes OTHER than the LIBOR (such as MTA, COFI, COSI, etc.) the majority of the adjustable rate mortgages (especially subprime ARMs) are based on LIBOR. Check your loan documents to determine your index.
So you can see what the problem is. The calculation of what your adjustable rate mortgage interest rate is during the adjustable period is disconnected from the Fed actions. That’s because what the Fed does is having little effect on the current credit crunch - and more importantly what the banks perceive as the appropriate cost of risk. So even as the Fed cuts rates the majority of adjustable rate mortgage holders will see little relief from skyrocketing adjustable rate mortgage rates and payments.
The only way people with LIBOR based ARMs get relief from higher adjustable interest rates is when the banks start trusting each other, until then it’s up, up and away, unfortunately.