The Secured Overnight Financing Rate (SOFR) is the benchmark interest rate that has replaced the London Interbank Offered Rate (LIBOR) in the U.S. In fact, for the past several years, lenders have been gradually switching from using LIBOR to determine rates for consumer loans, such as student loans, to using SOFR.
Here’s what you need to know about SOFR, including how it differs from LIBOR, and how you might be impacted by the change.
Key Points
• The Secured Overnight Financing Rate (SOFR) serves as the primary benchmark for interest rates on loans in the U.S., replacing the previously used LIBOR.
• SOFR is based on actual secured transactions, making it more reliable and less susceptible to manipulation compared to LIBOR’s hypothetical rates.
• The Federal Reserve Bank of New York publishes the SOFR daily, reflecting the rates financial institutions pay for overnight loans backed by Treasury securities.
• The transition from LIBOR to SOFR has been gradual, with minimal impact on borrowers, especially those with fixed-rate loans.
• Understanding the differences between SOFR and LIBOR is crucial for borrowers, as variable-rate loans may see adjustments based on the new benchmark.
What Is the Secured Overnight Financing Rate (SOFR)?
Financial institutions now use Secured Overnight Financing Rate, or SOFR, as a tool for pricing corporate and consumer loans, including business loans, student loans, mortgages, and credit cards. SOFR sets rates based on the rates that financial institutions pay one another for overnight loans (hence the name). The SOFR rate is published daily by the Federal Reserve Bank of New York.
SOFR is a popular benchmark because it is risk-free and transparent. It is based on more than $1 trillion in cleared marketplace transactions. This in contrast to the index it has replaced, the London Interbank Offered Rate, better known as LIBOR. LIBOR was based on hypothetical short-term loan rates. This has historically made LIBOR less reliable and more vulnerable to insider manipulation.
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How Does the SOFR Work?
When large financial institutions lend money to one another, they must adhere to reserve and liquidity requirements. They do this by using Treasury bond repurchase agreements, known as “repos”. Using repo agreements, Treasurys are used as collateral and banks are able to make overnight loans.
The SOFR interest rate index is made up of the weighted averages of the interest rates used in real, finalized repo transactions. Every morning, the New York Federal Reserve Bank publishes the SOFR rate it has calculated for repo transactions on the previous business day.
Current SOFR Rates
The New York Federal Reserve publishes the SOFR rate every business day. The latest rate is:
5.06% on July 25, 2023
The History of SOFR
Financial institutions, banks, and lenders rely on certain indexes to determine interest rates. Before the 1980s, there wasn’t one particular index that was used internationally. However, during the 1980s, increased complexity in the market resulted in the need for more standardized use of a benchmark tool for determining adjustable rates.
The international financial industry adopted LIBOR as the standard because it was viewed as a trusted, accurate, and reliable index. Other indexes were still used, but the majority of institutions used LIBOR. LIBOR rates were once the basis for about $300 trillion in assets around the world.
Fast forward to around 2008, and certain large financial institutions were manipulating interest rates illegally in order to increase their profits. This was possible in part because LIBOR is based on hypothetical rates. Manipulation of rates was one factor that led to the financial crisis.
Once that manipulation was discovered, there was a global demand for a new rate benchmark and a call to end the use of LIBOR. As a result of the 2008 financial crisis, banking regulations led to less borrowing and a lessening of trading activity. Less trading made LIBOR even less reliable.
In 2017, the Federal Reserve formed a group of large financial institutions known as the Alternative Reference Rate Committee (ARRC) to work on finding an alternative to LIBOR. They ultimately chose SOFR.
Both LIBOR and SOFR were being used by banks and lenders until June 2023, when SOFR became the standard in the U.S.
How SOFR Is Different From LIBOR
There are some key differences between SOFR and LIBOR, which help explain the shift towards SOFR and away from LIBOR. Here’s a look at some of the biggest.
• SOFR is based on completed transactions, whereas LIBOR is based on the rates that financial institutions said they would offer each other for short-term loans. Because it’s based on hypotheticals, LIBOR is more vulnerable to manipulation.
• Lending based on LIBOR doesn’t use collateral, making it unsecured. Loans using LIBOR include a premium due to credit risk. SOFR, on the other hand, is secured, as it is based on transactions backed with Treasurys. Therefore, there is no premium included in the interest rates.
• SOFR is a daily (overnight) rate, while LIBOR has seven variable rates.
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How SOFR Could Affect You
There has been some concern that the shift away from LIBOR would cause great market disruption. However, the changeover was designed to be slow and gradual and, generally, hasn’t caused any sudden changes for borrowers.
In fact, if you have a federal student loan or a private student loan with a fixed-rate, the change from LIBOR to SOFR has not — and will not — have any impact on your loan, since the rate is fixed for the life of the loan. If you are entering into a new loan, SOFR rates are already being used.
If you have a student loan (or any other type of loan) with a variable rate, the shift from LIBOR to SOFR may have impacted your loan — but likely not in any noticeable way. Switching from one index (LIBOR) to another, largely similar index (SOFR) — in the absence of any other market changes — won’t have much impact on a loan’s interest rate, according to the Consumer Financial Protection Bureau .
The rate on an adjustable-rate loan can go up and down over time. These changes, however, are largely due to general ups and downs in interest rates across the economy. Loan rates have been going up across the board, but that is not due to the shift from LIBOR to SOFR. Rather, it’s the result of efforts by the Federal Reserve to tamp down inflation.
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The Takeaway
If you have a student loan, you may have received a notice from your lender or servicer about a change in the index rate for your loan. Instead of LIBOR, lenders in the U.S. are now using SOFR. The indexes work in a similar way and it should not have a major impact on your loan. If you’re in the market for a new loan, you won’t be affected by the switch, since U.S. lenders have already made the shift to SOFR.
Keep in mind, though, that interest rates on loans are based on numerous factors, including general market conditions and your (or your cosigner’s) qualifications as a borrower.
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