This page discusses the impact of historical changes in the spread between the Prime Lending Rate and LIBOR index on the cost of private student loans. It argues that private student loans which are pegged to the LIBOR index are better than those pegged to the Prime Lending Rate, all else being equal, since the spread between the Prime Lending Rate and LIBOR index has been growing over time.
The interest rates on variable rate private student loans are usually specified as the sum of a base rate (also called an index ) that varies, plus a margin that does not. About half of private education lenders offer variable rate private student loans that are pegged to the LIBOR index, about 2/5 to the Prime Lending Rate, and the rest to the 91-day T-bill.
- LIBOR is an acronym for the London Interbank Offered Rate, and is also known as Eurodollar deposits. It is the average interest rate paid on deposits of US dollars in the London market. It is the interest rate at which lenders can borrow money from other banks. As such, it measures the cost of capital for a bank. Private student loans typically are based on either a 1-month or 3-month average of the LIBOR index.
- PRIME is the Prime Lending Rate as published in the Wall Street Journal. This is the rate banks charge their most creditworthy customers. It is commonly used in setting the interest rates on credit cards.
- 91-day T-bill is the 3-month US Treasury Bill. This is the cost to the federal government to borrow money.
- The spread between two indices is the difference between the interest rates.
Cost of Capital
Lenders earn revenue by borrowing money at one rate (the cost of capital) and lending it at another, higher interest rate.When a bank offers private student loans, it obtains the money it lends from one of four sources:
- Customer deposits.
- Capital raised by selling stock.
- Credit-warehousing facilities. These are loans from large international banks.
- Asset-backed securitization (ABS). This involves transferring the loans to a trust and selling shares in the trust to investors. The lender recovers the initial loan capital plus a premium. The lender may also receive deferred revenue from servicing fees and advisory fees.
Lenders start off using a credit warehousing facility as an initial and short-term source of funds, and securitize the loans when they have accumulated enough volume. Typically one needs at least $100 million in loans to securitize ($1 billion is more common).
Lenders prefer securitization over credit warehousing facilities because the cost of capital is usually lower. Both credit warehousing facilities and securitization involve paying interest at rates pegged to the LIBOR index, but the margins on credit warehousing facilities are often higher.
Lenders also prefer securitization because it gives them a portion of their profits up front in the form of the premium. Lender profitability depends on how quickly they can securitize their debt, since this reduces reliance on higher-cost credit warehousing facilities.
Since the interest rates on securitizations are pegged to the LIBOR index, many lenders prefer to peg interest rates on private student loans to the same index. It yields a more predictable profit margin. (Likewise, since securitizations assign different margins to different credit tranches, lenders have an incentive to vary interest rates according to credit risk.) If they peg the loan rates to the Prime Lending Rate, it can lead to "basis risk" and require the lender to employ interest rate swaps and hedging to limit the risk that the Prime Lending Rate and LIBOR index will change at different rates.
Some lenders use the LIBOR rate because it reflects their cost of capital. Other lenders use the Prime Lending Rate because PRIME + 0.0% sounds better to consumers than LIBOR + 2.80% even when the rates are the same.
Current Index Rates
Current LIBOR and Prime Lending rates can be found in the Federal Reserve's Statistical Release. The LIBOR rate appears in the London Eurodollar Deposits lines (1, 3 and 6 month figures) and the Prime Lending Rate appears in the Bank Prime Loan line.The current (weekly) interest rates are:
- Prime Lending Rate: 3.25%
- LIBOR (1 month): 0.29%
- LIBOR (3 months): 0.42%
- 91-day T-Bill: 0.09%
Spread between PRIME and LIBOR
The Prime Lending Rate tends to be 2.5% to 3.5% higher than the LIBOR rate and 2.8% to 4.0% higher than the 91-day T-Bill. For example, the 3 month LIBOR for July 1, 2005 through September 30, 2005 was 3.38%, while the Prime Lending rate was 6.00%. The difference between the two indices was 2.62%.
The current spread between the Prime Lending Rate and the 3-month LIBOR is 2.83%. The current spread between the Prime Lending Rate and the 1-month LIBOR is 2.96%.
The LIBOR rate tends to be slightly above the 91-day T-Bill rate and to track changes in the 91-day T-Bill rate and federal funds rate. However, during the subprime credit crisis of 2007 and 2008, the LIBOR index was sustained at higher levels than before because of turmoil in the asset-backed
securitization (ABS) markets.
The Prime Lending Rate tends to be somewhat more volatile than the LIBOR rate. The general trend with the Prime Lending Rate is to lag decreases in bank cost of capital but to immediately reflect increases. However, private student loans that are pegged to the 3-month LIBOR will take an additional two months to catch up to changes in the index.
Historically, the spread between the Prime Lending Rate and LIBOR has been increasing, meaning that over the long term a loan with interest rates based on LIBOR will be less expensive than a loan based on the Prime Lending Rate. A variable rate loan pegged to the LIBOR index will grow more slowly than a loan pegged to the Prime Lending Rate.
The following chart illustrates the spread between the Prime Lending Rate and the 1-month and 3-month LIBOR indexes since 1971. As is evident from the chart, the spread has been growing over time. It has been relatively stable for the 15-year period from 1992 to 2007. (Volatility has also been decreasing.) Even so, there is a slight advantage for loans pegged to LIBOR. For example, consider a loan originated in January 1997 at LIBOR + 2.8% (8.24%) vs PRIME (8.25%). The average monthly rate for PRIME over the ten year period from 1997 to 2006 would have been 6.82%, compared with 6.77% for one pegged to the 3 month LIBOR. There's less of a difference if the variable rate is pegged to the 1 month LIBOR.
Historial data is not necessarily predictive of future movement in interest rates. Since the typical private student loan has a repayment term of 20 or 25 years and a somewhat shorter average life, the borrower must make a bet on which interest rate will grow more slowly.
Competitive pressure will increasingly lead to long-term stability in the spread between PRIME and LIBOR. The cost of capital for most major lenders is similar, leading to similar consumer interest rates. Since most lenders publish the interest rates they charge, there is little reason for one major lender to undercut the others on price, since they know that the others will quickly match rates. Any advantage will be short-lived. Aside from branding, marketing and other secondary factors, debt functions like a commodity. Money is fungible; it doesn't matter much who the lender is, so long as the loan can be used to pay the bills.
Smaller fringe lenders sometimes try undercutting the larger lenders, but this does not have much of an impact on the Prime lending rate for several reasons. First, the smaller lenders by definition have little market share and so don't have much of an impact on the overall average. Second, the economy of scale favors the larger lenders, who are able to reduce their cost of capital by securitizing more frequently. The larger lenders could easily afford to undercut the smaller lenders to drive them out of business if they considered the smaller lenders to be a threat. But they don't cut rates because there's no upside to their cutting rates. Smaller lenders can compensate for lower per-loan profits by increasing market share; larger lenders can't. However, if a smaller lender is successful in growing by cutting rates, they will eventually feel pressure to increase profits and will gradually increase interest rates on new loans.
So while there may be short-term influences that monentarily affect the spread between PRIME and LIBOR, long-term the spread will be increasingly stable.
Advice for BorrowersThis leads to the following advice for prospective borrowers of private student loans:
But be sure that the difference is real. Focus on the actual interest rate and not the advertised "as low as" rate. Beware of teaser rates that mask a higher interest rate later on. Also be careful to factor in the impact of higher fees on the cost of the loan. But be careful comparing loans based on APR, as APR is not a good tool for comparing loans that have different loan terms. (All else being equal, the APR will be lower on a 25 year loan as compared with a 20 year loan.)
Of course, borrowers who are eligible for federal education loans should exhaust their federal loan eligibility before resorting to private student loans, as the federal loans are generally less expensive. (There are a few exceptions where private student loans offered by nonprofit state loan agencies are less expensive, but private student loans offered by commercial lenders are generally much more expensive than federal loans. For example, the average interest rate on private student loans in 2007 was about 2% higher than the Federal PLUS loan interest rate and about 4% higher than the Federal Stafford loan interest rate.)