SOFR (Secured Overnight Financing Rate)
What Is SOFR?
SOFR, or the Secured Overnight Financing Rate, is a benchmark interest rate used to measure the cost of borrowing cash overnight using U.S. Treasury securities as collateral. It is widely used as a reference rate for loans, mortgages, derivatives, and other financial products.
SOFR was introduced by the Federal Reserve as a replacement for LIBOR (London Interbank Offered Rate), which was phased out due to concerns about transparency and manipulation.
Why It Matters
SOFR plays a key role in determining interest rates for many financial products. When lenders use SOFR as a benchmark, the final interest rate on a loan is often calculated by adding a fixed margin or spread to the SOFR rate.
Because SOFR is based on real transactions in the U.S. Treasury market, it is considered a more reliable and transparent benchmark than LIBOR.
How SOFR Works
SOFR is calculated daily using data from transactions in the U.S. Treasury repurchase agreement (repo) market. In these transactions, financial institutions borrow cash overnight while pledging Treasury securities as collateral.
Financial contracts may use SOFR in formulas such as:
Benchmark Rate + Spread = Loan Interest Rate
Because SOFR reflects short-term borrowing costs, changes in market conditions can influence SOFR levels and, in turn, affect borrowing costs for loans tied to the benchmark.
Example
A loan agreement may specify an interest rate equal to SOFR + 2%. If SOFR is 3%, the borrower’s interest rate would be 5%.
SOFR vs LIBOR
- LIBOR was based on estimates from banks about borrowing costs.
- SOFR is based on actual market transactions in the Treasury repo market, making it more transparent and less vulnerable to manipulation.
FAQs About SOFR
Why did SOFR replace LIBOR?
LIBOR was phased out due to concerns about rate manipulation and limited transaction data.
Does SOFR change daily?
Yes. SOFR is published daily based on overnight lending transactions.
Do consumer loans use SOFR?
Many adjustable-rate loans and financial contracts now use SOFR as the benchmark rate.
Related Terms
