LIBOR vs. Prime (interest rates)

Before borrowing an obscene amount of money for school, I thought I’d ask for financial advice on the internet!

    I'm borrowing a boatload of money (100,000+) for school that I plan to pay off in 13 years.  My best options are a fixed 8.5% rate vs. a variable rate based on the 3-month LIBOR.  Right now, that rate will come out to be around 6%.  

    So the question is, over the next 13 years, will the LIBOR increase by more than 2.5%, and will it do so rapidly enough to make it cheaper to borrow on the 8.5% rate?  Also, what is the highest the LIBOR could reasonably rise to?

      I welcome your educated guesses.

If inflation in the US picks up a great deal, all bets are off. I’m guessing that won’t happen.

The Fed funds rate is currently at 5%. The core inflation rate is at 2.3%. On average the differential between the two is about 1.75%. (Now the differential is 2.7%). A differential of 4.0% is very high. 3.0% and higher is very reasonable during an expansion.

Expect short-term rates to be 0.25- 0.50 percentage points higher by the end of the summer. I find it unlikely (again, not impossible) that the Fed funds rate will go above 6.25% (a 1.25% point increase), in the next 2 years.

If, OTOH, core inflation went to 4%, then the Fed Funds rate could easily go to 7%. But I think that scenario is unlikely over the next 2-3 years.
BTW: the newest core inflation figure comes out next week. The latest 2.3% figure was unexpectedly high. Let’s hope that it was a 1 month blip, and that it recedes to 2.1%.

LIBOR and the Fed Funds rate should move together, though there may be a spread between them. They’re both short term rates: I’m not as familiar with LIBOR.

Thirteen year forecast:

John McCain will be elected President and pledge to continue the sound money policies of Federal Reserve Chairman Ben Bernanke, who was just appointed by GW Bush in early 2006.

McCain will disappoint liberals. Nationally, he will have a spell of wild popularity, followed by mere popularity. When he is merely popular, pundits will opine how interesting and surprising that is, though it will be neither. McCain will be in office for two terms. Donald L. Kohn will be Bernanke’s successor No he won’t, he will be a little old and long-time Fed officers rarely reach the pinnacle of the Fed.

The country will grow tired of congressional Republicans, notwithstanding tiresome comparisons of McCain with Eisenhower. Barak Obama will be elected President and maintain the sound money policies of his predecessor.

During this period, the US will not win the World Cup. Core inflation will remain below 5%. Target inflation levels may rise after a few years (from 1-2% to 2-3%) as they are probably too low now, but don’t count on it. Fed Chairman like to appear hawkish.

So, it is safe to expect rates to rise in the absence of significant inflation? Or have I got my macro-economics backwards?

Reading more, I realize that I can get my rate down to 7.2% for the fixed rate. So that would seem to be the way to go, no?

Higher inflation tends to lead to higher interest rates.

Let’s say core inflation goes up to 2.5%. Let’s say the real fed fund rate (where real fed fund rate = fed funds rate - core inflation) averages 3% over the next 13 years. That would be a somewhat pessimistic forecast. 2.5+3=5.5%. That is .50% above what we have now.

Mind you though, you should expect the fed funds rate to hover above 5.5% a lot over the next 13 years. Heck, expect it within the next 12 months. I’m predicting that the average rate should be below that level though.

So if the difference between your current variable rate and your fixed rate is greater that one half of a percentage point, I would personally choose the variable rate. Otherwise, I’d rework the figures.
There’s a saying, by the way: “If you must forecast, forecast often.” So that last paragraph is definitely not a generalization. Put another way, it would have been really bad advice 1 year ago.

Oh, and unless you’re familiar with my posts don’t take my advice. Rather, evaluate my argument as best you can. Taking financial advice from Joe Anonymous seems a little hazardous.

[Moderator Hat ON]

I think this will do better in IMHO.

[Moderator Hat OFF]

LIBOR is the London interbank rate, published by the British Bankers association. It’s basically the european equivilant of the Fed Funds rate, and yes, they shoudl move pretty closely in lock step. As of Friday, IIRC (I’m not at work so can’t easily look it up ) is like 5.38%. The forward curve for the LIBOR we are using 5 years out is pushing 6+%, but obviously that changes based on market condisions. Based on your 2.5% mark… is the spread LIBOR + 250bp (2.5%) then on this prospective loan? So that would make the rate 7.88%?

It really comes down to your risk, and the potential ability to refinance at a lowe spread later on.

Hope that helps.