Those of us born without silver spoons in our mouths finance our education and major purchases with loans. Banks also need credit. They borrow from and lend to each other to comply with reserve requirement laws and pass the cost on to their customers. Depending on the financial institution and the type of loan, either the London Interbank Offer Rate -- LIBOR -- or the prime interest rate determines how much borrowing will cost companies and consumers.
The most favorable interest rate consumer and business borrowers can get is the prime rate. U.S. banks calculate their prime rate according to the interest rate, or federal funds rate, they pay to borrow from each other. The "Wall Street Journal" publishes a national prime rate based on what the country's 30 largest banks charge their most creditworthy customers. According to Bank of America, the WSJ prime rate may be the same as any one bank's prime rate. Bank of America prices its loans using factors such as economic conditions, costs and desired profit and considers the national prime rate as "a reference point." Home equity lines of credit, personal and small-business loans, auto financing and credit cards carry interest rates based on the prime interest rate.
When U.S. banks borrow from foreign banks, they pay an interest rate known as the London Interbank Offer Rate, or LIBOR. Thompson Reuters calculates the LIBOR and publishes it daily on behalf of the British Bankers' Association. While monetary policy influences the prime rate, supply and demand cause LIBOR rates to fluctuate constantly. Unlike the prime rate, LIBOR is not one rate; LIBOR exists in different loan maturities and 10 currencies. For example, the one-week U.S. dollar LIBOR rate applies to an interbank loan of dollars for a one-week period. U.S. banks use this international interest-rate benchmark when establishing lending fees for adjustable-rate mortgages. The extent of their global banking activity makes LIBOR an accurate reflection of their cost of doing business, according to Guidance Mortgage.
LIBOR and Student Loans
According to FinAid, a college financing information website, approximately 50 percent of financial institutions that offer private student loans use the U.S. dollar LIBOR. They calculate the variable interest rate on these loans using either the one- or three-month average plus a margin. Borrower credit history and loan repayment terms also affect the actual interest rate charged. Mark Kantrowitz, author of several books on student financial aid, notes that LIBOR-based college loans will cost less than those based on prime rate on a long-term basis.
Banks in the European Union address their interbanking needs with short-term financing based on LIBOR or the Euro Interbank Offered Rate -- EURIBOR EURIBOR was born when the EU adopted the euro as its currency. Like LIBOR, EURIBOR comes in different maturities and is published daily. Thompson Reuters calculates EURIBOR using the interest rates from 43 panel banks within the European Banking Federation.
- U.S. Federal Reserve: Monetary Policy; Reserve Requirements
- Guidance Mortgage: What Fed Rates Cuts Do for You
- BankRate.com: Wall Street Journal Prime Rate
- Bank of America: Prime Rate Frequently Asked Questions
- BankRate.com: Prime Rate, Fed Funds, COFI
- Home Finance.nl: What Is Euro LIBOR?
- “Guide to Economic Indicators: Making Sense of Economics;” The Economist Newspaper
- Home Finance.nl: U.S. LIBOR Interest Rates
- FinAid: Spread Between Prime and LIBOR
- Comstock/Comstock/Getty Images