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LIBOR is being phased out in 2021. What now?

Under SOFR, 7/6 adjustable-rate mortgages are seeing some popularity

Mortgage lenders are preparing for the end of LIBOR, which is set to be phased out by the end of 2021. 

Financial institutions have been searching for alternatives since regulators in the United Kingdom stated that LIBOR cannot be guaranteed beyond next year. LIBOR is commonly used in setting the interest rate for many adjustable-rate consumer financial products and its end will affect adjustable and variable rate loans, reverse mortgages, credit cards, home equity loans, and adjustable-rate mortgages. 

How are lenders proceeding, then?

The most viable replacement is the Secured Overnight Financing Rate (SOFR) index, which has been recommended by the Alternative Reference Rates Committee (ARRC) and endorsed by the New York Federal Reserve.

In fact, Freddie Mac began officially purchasing SOFR-based “floating rate mortgages” in October, and announced in a press release that it will “cease all LIBOR-indexed loan purchases by the end of the year.” 

“Throughout the past year we have worked to ease the transition away from LIBOR with more than 20 K-Deals that included bonds indexed to SOFR,” said Robert Koontz, senior vice president of Multifamily Capital Markets. “The collateral for those offerings was LIBOR-based and Freddie Mac covered the basis mismatch. With purchases of SOFR-indexed loans gaining momentum, we’re now able to offer the first tranche of SOFR bonds backed by SOFR collateral.”

SOFR represents a cross section of widely used, highly reliable assets and does not rely on self-reported data. The ARRC has insisted that SOFR is a much more resilient rate than LIBOR because of “how it is produced, and the depth and liquidity of the markets that underlie it.” 

Per the ARRC, “the volumes underlying SOFR are far larger than the transactions in any other U.S. money market. This makes it a transparent rate that is representative of the market across a broad range of market participants and protects it from attempts at manipulation.”

Rudy Orman, director correspondent for sales and product development at Reliant, said SOFR is based “purely on transaction overnight rate data,” while LIBOR is more of a utility price with “a credit and rate swap built in.”

“Because it’s more transactional, SOFR is more volatile, but directionally, they move similarly,” he said. “SOFR is not a perfect index, but it appears to be the closest substitute. It’s similar to comparing a bike to a car – they both are different modes of transportation, and it’s better than having no bike or no car.” 

Using SOFR, Institutions are also employing the use of 7/6 ARMs, which reset every six months and are more relaxed than a 7/1 LIBOR ARM, said Saro Vasudevan, president of HomeLight Home Loans. As an example, if a 7/6 ARM had a lifetime cap of 4% and it started at 3%, the ARM’s interest rate would never go beyond 7% regardless of what happened in the market.

“We are doing more 7/6 SOFR ARMs now than the number of 7/1 LIBOR ARMS we used to do before,” Vasudevan said. “Since the SOFR rate is currently much lower than LIBOR rate, this makes interest rates very attractive.”

Vasudevan added that consumers who choose 7/6 ARMs shouldn’t be wary of rate changes, and that “anyone” who qualifies for a 30-year fixed-rate mortgage can also qualify for an ARM.

“In the way that people generally use the term ‘risk’ around mortgages, no, these are not riskier,” Vasudevan said. “The amount of mortgage they qualify for will differ, as 30 year FRM rates are traditionally higher than ARM rates. When that’s the case, you may qualify for a bigger loan with ARMs. For right now, there is still a fair bit of uncertainty in the mortgage capital markets, so ARM rates can be higher.”

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