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LIBOR vs SOFR and the Transition to SOFR, Explained

SOFR vs LIBOR Transition Need to Knows
Austin Kilham

Austin Kilham

Updated April 19, 2022
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The London Interbank Offered Rate, or LIBOR, has been an important benchmark used to determine the interest rates on commercial and consumer loans. LIBOR has been in use for more than 40 years, and if you’ve taken out a consumer or business loan in the past, it was likely pegged to LIBOR. However, all of that is changing.At the beginning of 2022, a major shift took place, and all loans issued in the U.S. were no longer using LIBOR as their benchmark. Instead, it has been replaced with the Secured Overnight Financing Rate, or SOFR. Why? Experts think it’s a more accurate and secure pricing benchmark. Here’s a closer look at the two benchmarks and what the transition means for consumers, investors, and businesses. 

What Is LIBOR?

All interest rates reflect market conditions to some degree, and LIBOR is defined by the interest rates large international banks (around 20) would charge each other for making overnight loans. How it works: Each day, these international banks submit their ideas of the rates they think they would pay if they had to borrow money from another bank on the interbank lending market. To help guard against extreme highs or lows that might skew the calculation, the highest and lowest rates are then removed and these rates are averaged together to create the daily LIBOR rate.LIBOR became an important tool for pricing a variety of financial instruments. Some you may be familiar with, such as adjustable-rate mortgages, student loans, and municipal bonds. For example, if you carried an adjustable rate mortgage, the rate was likely set by using the LIBOR and adding an additional percentage to arrive at your actual interest rate. Other factors such as your credit score would also be taken into consideration. The benchmark was also used for other more sophisticated instruments that may be less familiar, such as asset-backed securities and credit default swaps. The LIBOR was tied in some way to as much as $300 trillion worth of financial instruments. Though the LIBOR will no longer be used for loans in the U.S., it hasn’t disappeared yet and will continue to be published until some time in 2023. Some loans may hang on to it as their benchmark until that time.

What Is SOFR?

SOFR is also a benchmark that financial institutions use to price loans for businesses and consumers, but it’s based on the cost of borrowing money overnight when the borrower puts up U.S. government debt as collateral. How it works: Banks lend money to each other using U.S. Treasury bond repurchase agreements, also known as repos. These repos allow the banks to make overnight loans to help them meet federal liquidity and reserve requirements, using the Treasuries as collateral. The weighted averages for the rates banks charge each other in these transactions are used to calculate SOFR. While the details may sound complicated, what's important to note is that with SOFR, the rates are actual, not hypothetical (as they are with LIBOR), and its sample size is significantly larger than LIBOR.SOFR is being used in the U.S. as a replacement for USD LIBOR, and it will likely be the dominant benchmark globally. However, other countries are coming up with their own benchmarks as well, based on their own currencies and economies.

SOFR vs LIBOR: What Are the Major Differences?

There are several distinct differences between SOFR and LIBOR. First, SOFR is based on transactions in the largest rates market in the world, to the tune of roughly $1 trillion per day. LIBOR, on the other hand, is based on a handful of transactions that are likely worth several hundred million dollars. And the number of transactions is falling, which is one of the reasons experts pushed to transition away from using LIBOR as a benchmark. What’s more, while SOFR is based on observable transactions, LIBOR is based on expert estimates and judgment.Also, SOFR is a backward-looking overnight rate, meaning it’s calculated based on events that have already happened. LIBOR is a forward-looking rate based on estimates of what will happen in the future. Finally, SOFR is secured and risk-free, because it is collateralized by U.S. Treasury bonds. This means that risk isn’t really taken into account by the measure. LIBOR is unsecured and includes credit risk as a part of its measure. Here’s a look at the differences between SOFR and LIBOR at a glance: 

Why Is LIBOR Being Replaced?

There are a number of reasons why LIBOR is being replaced. For one, transaction volume in the underlying market that determines LIBOR is not big enough anymore. A relatively small group of banks determines rates based on its own judgment, and experts increasingly question its credibility.  LIBOR is also being phased out for the role it played in worsening the 2008 financial crisis and for scandals involving manipulating the rate. Just prior to 2008, a variety of risky mortgages and other financial products were insured by financial companies using credit default swaps, the rates for which are set by LIBOR. American International Group (AIG) was one of the largest issuers of credit default swaps on subprime mortgages, and when the company failed, the effects rippled out across the financial system. Banks, including LIBOR-setting banks, became reluctant to lend to each other, and interest rates rose higher and higher making loans more expensive despite the efforts of central banks to lower interest rates.Thus LIBOR became one of the driving forces of the financial crash. And, in 2012, investigations into the way LIBOR was set uncovered a long-term scheme among several large banks to manipulate the LIBOR for profit.Because SOFR is based on the huge Treasury repurchase market, which is based on real transactions, it is much less likely that any one entity could manipulate it. 

LIBOR to SOFR Transition: What You Need to Know

Some worry that the transition from LIBOR to SOFR will be abrupt and send shockwaves through the financial markets. In reality, the transition is designed to be slow and gradual. In fact, it has been underway for years, and it will likely take a number of years for LIBOR contracts to fully work their way out of the financial system. 

Effects on Consumers

The USD LIBOR is expected to meet its end on June 30, 2023, which will affect some adjustable rate loans and lines of credit, such as adjustable-rate mortgages, reverse mortgages, home equity lines of credit, credit cards, student loans, and other debts. While this could lead to a slight adjustment in rates, for most consumers the switch from LIBOR to SOFR won’t be particularly noticeable. However, If you have an adjustable-rate mortgage, home equity loan, reverse mortgage, or student loan, you might want to reexamine the fine print and find out exactly how your rate is determined. If it’s already SOFR- or Treasury-based, nothing will change, but if it’s a LIBOR-based loan, you may want to speak to your lender about when it will change over (or if it already has) and what that could mean in your individual situation.The switch is already in effect for new loans. 

Effects on Investors

In the past, LIBOR has been used as a benchmark for a variety of types of investments, including municipal securities, derivatives contracts, floating-rate notes, and collateralized loan obligations. Some mutual funds and exchange-traded funds (ETFs) will also invest in securities that are linked to the LIBOR. For the most part, these are fairly sophisticated investments, and the average investor may only have exposure through mutual funds, ETFs, and municipal bonds. The Federal Reserve created a group known as the Alternative Reference Rates Committee (ARRC) to aid financial institutions in the transition away from the LIBOR index. They have identified SOFR as the preferred replacement and they’ve established steps institutions can take to help make the transition as smooth as possible. 

Effects on Businesses

The switch from LIBOR to SOFR will have many of the same effects on businesses as individuals. The shift to SOFR for various kinds of business loans has been underway since 2017, and, as with individual loans, it is no longer used for new loans as of 2022. When comparing business loans or applying for a new business loan, companies should now see SOFR or another benchmark rate used to determine their interest rate.  Businesses should review lending agreements to see whether LIBOR was used and whether there is a fallback provision that has established a new rate. In some cases, businesses may want to update internal systems, such as IT systems that manage loans and calculate interest. Financial institutions will likely feel the greatest impact from the shift to SOFR as they reconfigure products while doing what they can to minimize the impact of the shift. 

Alternatives to SOFR

While the Federal Reserve Board has made clear that SOFR is its preferred benchmark rate for short-term interest rates, some alternatives have been developed which index unsecured rates. The American Financial Exchange (AFX) has developed AMERIBOR, Bloomberg developed the Short-Term Bank Yield Index, and The Intercontinental Exchange (ICE) created its Bank Yield Index. The rates developed by the AFX, ICE and Bloomberg are credit sensitive rates, unlike SOFR. Supporters of these rates say they are a better reflection of a lender’s true cost of funds — the amount banks must spend to acquire money to lend — which could make more money available at lower costs to borrowers. 

The Takeaway

For the average consumer, the switch from LIBOR to SOFR will not be a big deal. Individuals and businesses looking to acquire a new loan will likely notice that their interest rate is already being calculated based on the SOFR benchmark. Individuals or businesses who already carry some form of debt, especially debts with adjustable rates, may experience a shift as their lender makes the transition. However, there are many more factors that go into determining the interest rate besides the benchmark rate. If you’re applying for a small business loan, such as an SBA loan, lenders will look at your credit scores (both personal and business), time in business, annual revenue, and collateral when determining whether or not to loan you funds and at what rate. If you’re interested in finding out what type of small business loan you might qualify for, Lantern by SoFi can help. With our online lending tool, you can immediately get offers from multiple small business lenders with just one application and without making any type of commitment.
Photo credit: iStock/ Nicholas Ahonen
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Frequently Asked Questions

Will SOFR replace LIBOR?
Why is SOFR lower than LIBOR?
How is SOFR determined?
How is LIBOR determined?

About the Author

Austin Kilham

Austin Kilham

Austin Kilham is a writer and journalist based in Los Angeles. He focuses on personal finance, retirement, business, and health care with an eye toward helping others understand complex topics.
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