If your card’s reference index is LIBOR, rather than the prime rate, it will be replaced with a different reference index as the financial world phases out LIBOR.
If your credit card debt comes with a variable interest rate that’s tied to the London Interbank Offered Rate, you will likely be impacted by the phasing out of the LIBOR index.
Starting in 2021, the financial world is preparing to transition away from LIBOR as a reference index and gearing up for another index, the Secured Overnight Financing Rate (SOFR), to take over from LIBOR.
If the interest rate on your credit card debt is adjusted based on movements in LIBOR, which serves as a reference index, rather than the prime rate to which most credit card interest rates are tied to, you need to be aware of the potential impact.
Your card issuer calculates the interest rate you are charged on variable-rate card debt by using the rate on the reference index, which varies based on market conditions, as a base and then tacking on a margin to it, say 10%.
So this change could have consequences for you. If the base index rate rises, the interest rate your issuer charges you, and the amount of interest you will pay, will go up too. Talk to your card issuer to find out if the transition will impact you.
See related: How does credit card interest work?
What’s behind the LIBOR transition?
LIBOR has been in use since 1969. It’s a reference rate at which large creditworthy banks say they are able to borrow money short-term from each other without offering any collateral security to back the borrowing. It’s an average rate that is based on input from several banks.
After the 2008 financial crisis, there were suspicions aroused that some of the input provided by these banks was manipulated. It seems that they misrepresented their borrowing costs as lower in order to present themselves as more financially healthy than they actually were. There were also allegations that some of these banks were trying to boost their gains on contracts tied to LIBOR. Banks implicated in such misrepresentations include RBS, UBS and Barclays.
Considering that a reference rate such as LIBOR, which serves as a basis for financial transactions that total trillions of dollars, should not have its credibility questioned, financial market regulators worldwide began the process of reform in 2012.
In 2014, the Federal Reserve brought together a group of market participants (including banks, asset managers, insurers and trade associations) to form the Alternative Reference Rates Committee. This committee has been looking into a LIBOR alternative and has recommended a transition to the SOFR.
According to Nathaniel Wuerffel, senior vice president at the Federal Reserve Bank of New York, a “robust reference rate” should have three main characteristics.
“First, a reliable administrator with strong and resilient production and oversight processes,” Wuerffel said via videoconference at a Bank Policy Institute symposium in September. “Second, it should be clear what market the rate represents and how it measures that market. And third, it should be based on a market that is deep and broad enough that it does not dry up in times of stress, is resilient even as markets evolve over time and cannot easily be manipulated.”
The ARRC favors the SOFR index as a replacement to LIBOR considering that it satisfies these criteria. SOFR is “a broad measure of the cost of borrowing cash overnight in the U.S. Treasury securities repurchase agreement (repo) market.” This index is based on actual transactions and is produced by the New York Federal Reserve.
Although your loan documents could specify an alternative index, if it’s not indicated lenders have the discretion to use a new reference rate with LIBOR becoming unfeasible.
See related: How credit scores affect interest rates
Regulation Z disclosure changes to aid transition
Card issuers are supposed to provide adequate disclosures to borrowers about their lending transactions under the Truth in Lending Act, which is implemented by Regulation Z.
The Consumer Financial Protection Bureau has come up with a rule to amend certain provisions of Regulation Z to make it easier for lenders to comply with TILA and provide notice to borrowers about the changes to their lending terms as a result of the LIBOR transition. The CFPB rule would permit card issuers to transition to a new index as early as March 15, 2021.
The proposed changes include:
- Permitting issuers that use LIBOR as their reference index to replace it with another one even though LIBOR continues to be available. This would facilitate an earlier transition even though LIBOR would only be phased out at the end of 2021.
- The effective annual interest rate you pay based on the new index and margin should be “substantially similar” to the rate you pay based on the LIBOR index and the applicable margin, using the two index values as of Dec. 31, 2020, rather than the date on which LIBOR becomes unavailable.
- There are also stipulations about how to select a replacement index. If the replacement index has been in use for a while, so that it has a history of readings, its historical fluctuations should be “substantially similar” to those of LIBOR. The CFPB is proposing that both the prime index and the SOFR index meet this criterion.
- Issuers should inform you in disclosures about changes in terms which index they are replacing LIBOR with, and about any adjustment to the margin they use, whether it is going to be a higher or lower margin.
- In case the LIBOR transition results in a higher interest rate to borrowers, issuers would not have to conduct an analysis reevaluating the rate every six months.
See related: How to lower your credit card interest rate
Is SOFR a good substitute index for LIBOR?
A number of comments received in response to the CFPB’s proposed rules question whether SOFR, which goes back to 2018 only, is a good alternative index.
In their joint comments, the American Bankers Association and the Consumer Bankers Association state, “There may be other indexes beyond SOFR and prime that are comparable or that have substantially similar fluctuations to LIBOR for purposes of Regulation Z such as AMERIBOR and Constant Maturity Treasury .”
Another point at issue is that SOFR is based on repo transactions backed by U.S. Treasury securities, which are risk-free, and does not add on a premium to reflect credit risk. LIBOR is based on an unsecured lending rate, and therefore factors in a credit risk component.
James Ciroli, chief financial officer at Flagstar Bank, noted, “AMERIBOR, like LIBOR and unlike a secured borrowing rate such as SOFR, fluctuates with interest rates in the credit markets and, as a result, can act as a built-in hedge during flight-to-quality events.”
The New York Fed sees the stability of SOFR as a positive.
“If the pandemic has confirmed one thing about financial benchmarks, it’s the resilience of robust reference rates, including SOFR,” New York Fed President John C. Williams said in a July speech. “On a backdrop of enormous turmoil and uncertainty, both in financial markets and the broader economy, SOFR was a dog that didn’t bark (or bite).”
Paul Noring, who leads Berkeley Research Group’s financial institution advisory practice, noted in emailed comments that the AMERIBOR is an alternative that is “gaining more traction” each quarter considering that “it has a credit spread” besides being “based on real transactions with sufficient depth.” It also meets financial industry bench mark standards and is starting to incorporate a wider range of rates.
Is there scope for lenders to take advantage?
There is also some concern about the potential for lenders to hike up interest rates as a result of the change. According to a comment from Sadis Alvarenga, responding to the CPBB’s public notice about its proposed changes, “Consumer advocates stressed the need for additional regulations that will prevent financial institutions from changing the index in a manner that will increase interest rates paid from customers.”
And a commenter named Vikram said, “It is absolutely imperative that lenders do not take advantage of this transition in whatever form or manner possible as some of them will surely do given the wide ambit of the change. What is the plan for oversight here?”
Also, an anonymous commenter observed, “Banks should be forced to not artificially inflate rates ahead of the sunset date. We are materially changing the terms of the loans and this leaves a lot of room for banks and financial institutions to use this as an opportunity to benefit themselves over their customers.”
How will LIBOR transition affect the credit card market?
At the end of the day, the LIBOR transition will likely have less of an impact on the credit card market than on other consumer loan markets.
According to Noring, “Cardholders like you and me will be less impacted by this change than the banks that provide the credit. On the consumer side the classes of borrowers that will have more impact are student loans, adjustable-rate mortgages and home-equity lines of credit.” The reason, he added, is that the margin added to the LIBOR index, or the spread, for credit card debt is huge, whereas the markups on the other forms of consumer credit are “much less.”
Besides, the prime rate is what most credit card interest rates are tied to. Maria Martinez, executive director of communications at Chase Card Services, noted, “All our variable rate APRs use the U.S. prime rate as our index. We don’t have any cards whose APRs are based on LIBOR. So the LIBOR to SOFR index transition is no impact and a nonevent for Chase credit card customers.”
Commerce Bank, Citizens Bank and Flagstar Bank, which are among the banks that use LIBOR as a reference index for their credit card loans, declined to comment on the impact of the LIBOR transition on their cardholders.