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The Secured Overnight Financing Rate (SOFR) is a key benchmark for interest rates in the U.S. It is replacing the London Interbank Offered Rate (LIBOR), which has long served as the main interest rate benchmark worldwide, but has fallen out of favor in recent years due to multiple scandals.Here’s what you need to know about the SOFR interest rate, how it works, and how the transition from LIBOR to SOFR will affect you as a consumer and small business owner.
What Is SOFR?
SOFR is a benchmark that financial institutions use to price many loans for businesses and consumers. The “Overnight Financing” part of its name refers to how SOFR sets rates for lenders: It’s based on the rates that large financial institutions pay each other for overnight loans. This differentiates it from LIBOR, which is based on the rates that financial institutions say they would offer each other for short-term loans, rather than actual transactions. SOFR also differs from LIBOR in that it is a backward-looking rate. SOFR tells you the overnight rate, but it doesn’t indicate what rates will be three or six months from now.
How Does SOFR Function?
SOFR is 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, 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. Because collateral is provided in order to borrow short-term cash, SOFR is a secured borrowing rate. LIBOR, on the other hand, is a rate for unsecured borrowing (where no collateral is posted).
How is SOFR Calculated?
SOFR is based upon the average interest rates banks are getting when they participate in these overnight lending contracts, or repo agreements. The U.S. Federal Reserve Bank of New York (FRBNY) calculates the SOFR by collecting actual data from major banks. The FRBNY then goes through the data and ranks all transactions according to their rates. Next, it calculates a weighted-average and publishes a daily SOFR rate by 8:00am.Although this rate is reported daily by the FRBNY, many lenders will set rates by looking at a rolling average, rather than the daily SOFR rate, in order to smooth out day-to-day volatility. Either way, the SOFR rate is not the actual rate a borrower would receive for a consumer or business loan. Lenders add a margin on top of SOFR, based on the creditworthiness of the borrower.
History of SOFR
SOFR’s history is intertwined with the history of LIBOR, which has been the go-to benchmark interest rate for decades. In fact, if it weren’t for LIBOR’s decline, SOFR would not likely be in the news.LIBOR’s troubles started just before 2008, when 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. As a result, LIBOR became one of the driving forces of the financial crash. Adding to LIBOR’s image problems: In 2012, investigations into the way LIBOR was set uncovered a long-term scheme among several large banks to manipulate the LIBOR for profit. Around the same time, changes to banking regulations were hurting demand for those interbank short-term loans that referenced LIBOR. This decreased the relevance of the benchmark.In 2017, the Federal Reserve created the Alternative Reference Rate Committee (AARC). AARC’s job was to find a suitable alternative to LIBOR. It had three criteria when selecting a replacement interest rate index:
The underlying markets needed to be robust.
Those markets needed to have a high amount of liquidity.
The rate index could in no way interfere with future decisions made by the Federal Reserve.
SOFR is what AARC came up with. 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’s phase-out began at the beginning of 2021. It will be fully replaced in the U.S. by SOFR on June 30, 2023.
Pros and Cons of SOFR
Pros of SOFR
Cons of SOFR
Less prone to manipulation than LIBOR
It’s only an overnight rate (LIBOR could be calculated up to 12 months in advance)
Released by the New York Federal Reserve, which is known for its credibility and objectiveness
Without a forward term rate, borrowers and lenders will not know a given interest payment until the end of each interest period
Based on huge volume of transactions
Doesn’t have a long history
Why SOFR is Replacing LIBOR
SOFR is replacing LIBOR because financial experts believe it is a more accurate and secure pricing benchmark. When comparing SOFR vs. LIBOR, one of the key differences is that SOFR is based on completed financial transactions, while LIBOR has come to rely on quotes from reporting banks that aren’t necessarily from actual financial transactions. Because SOFR is based on observable transactions, there is less opportunity for manipulation.Also, SOFR is based on extensive trading in the Treasury repo market, as opposed to LIBOR’s relatively small interbank lending market, theoretically making it a more accurate indicator of borrowing costs.
Transitioning From LIBOR to SOFR
The transition from LIBOR to SOFR is designed to be slow and gradual. In fact, it has been underway for years, and it will likely take a few more years for LIBOR contracts to fully work their way out of the financial system. While the transition is complex for financial institutions, consumers should not be significantly affected by the changeover.
How the Transition Affects Consumers
The shift from LIBOR to SOFR 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 a loan with an adjustable interest rate, 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.
Pros of Transitioning for Consumers
Cons of Transitioning for Consumers
Possible lower interest rates than LIBOR for variable rate loans
Difficult to reprice existing loan contracts because the benchmark rate will go from an unsecured rate to secured rate
Less susceptible to bank manipulation, which should help keep markets stable
It is not currently possible to gauge the price of long-term loan contracts using SOFR
Alternatives to SOFR
While SOFR has been in the spotlight, it isn’t the only LIBOR replacement available. There are a few other benchmark options that banks in the U.S. and abroad may choose to use.
SONIA
In the U.K., LIBOR is being replaced by the Sterling Overnight Index Average (SONIA). SONIA is managed by the Bank of England, and shows the average rates of overnight loans between banks and other institutions in the U.K.
Federal Funds Overnight index
The federal funds overnight rate is what U.S. banks pay each other for unsecured loans from their reserves held at the Federal Reserve. Some lenders are using an index of these rates — called the Federal Funds Overnight Index — as a replacement for LIBOR.
AmeriBOR
Created by the American Financial Exchange (AFX), AmeriBOR is an index based on the unsecured borrowing costs of small and medium-sized banks across the U.S. The information is stored via blockchain, and an index is created using a credit-weighted average of the unsecured loans involved.
U.S. Prime Rate
The U.S. prime rate is the interest rate banks charge their best customers for loans. It’s usually the lowest interest rate banks will charge and has been used for years as a benchmark to determine interest rates for other products, like lines of credit, credit cards, and small business loans.Recommended: What Is the Federal Discount Rate?
Frequently Asked Questions
Is SOFR higher than LIBOR?
Why is SOFR replacing LIBOR?
Is SOFR a secure borrowing rate?
Photo credit: iStock/BrianAJackson
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About the Author
Lauren Ward
Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
