What is a LIBOR Based Mortgage?

A LIBOR based mortgage is a type of adjustable rate mortgage (ARM) whose interest rate is based on an index called the London Interbank Offered Rate, also known as the LIBOR. ARM mortgages, as you may recall, have interest rates that vary depending upon the value of some index of financial instruments, and is derived from it by adding a fixed number called a margin.  The interest of an ARM is given by the following formula:  Interest Rate = Index + Margin

The LIBOR is an average of the interest that international banks charge each other to borrow United States dollars on the London market.  LIBOR type mortgages reduce the risk of international banks issuing mortgages in the US, because these mortgages offer additional protection from fluctuations in the value of the dollar.  For example, suppose an international bank issues a mortgage whose interest rate is LIBOR + 1.75%, where 1.75% is the margin.  Then, to make a guaranteed 1.75% profit, all it essentially needs to do is borrow the dollars at the interest rate of the LIBOR.

LIBOR mortgages are very similar to other adjustable rate mortgage and include similar features.  But, they also ease the burden of international banks and foreign investors issuing and buying US mortgages, and therefore are open to wider markets.  Consequently, LIBOR mortgages tend to have lower interest rates.  However, one drawback of the LIBOR ARM is the volatility of the LIBOR index.  LIBOR based mortgaged rates are therefore expected to have greater fluctuations than rates of other ARMs.