What Is The Secured Overnight Financing Rate (SOFR)?
If you’re even a little bit familiar with finances, you’re probably aware that interest rates are impacted by fluctuations in market demand. At the same time, you’re probably not aware what market activities impact which parts of your finances. For instance, you may have heard it’s related to mortgages, but what is SOFR and how does it impact your homeownership costs?
What Does SOFR Stand For?
The abbreviation “SOFR” refers to the Secured Overnight Financing Rate. Financial institutions use this interest rate when they borrow money after business hours.
The SOFR index is used by lending institutions as an index for the interest rates for a variety of financial instruments including adjustable-rate mortgages (ARMs). It’s just one rate used by banks to navigate short-term financing. Another is the federal funds rate.
How Does SOFR Work?
Banks pay the Secured Overnight Financing Rate to borrow secured loans that are backed by U.S. Treasury securities. This rate is determined by a volume-weighted calculation for the transactions made on the repurchase market.
In a standard repurchase agreement, the seller agrees to sell the security to the other party with the express agreement to buy it back at some point in the future. The process for buying the security back functions as the interest on what effectively is a temporary loan.
In order to come up with the SOFR rate, transactions are placed in order from lowest to the highest rate based on repurchase prices. Then they add the volume from all the trades made that day together and determine the rate associated with the trades in the exact middle of the dollar volume.
In addition to the daily SOFR rate, 30-, 90- and 180-day SOFR averages are published, which helps smooth any volatility in the index.
SOFR Vs. LIBOR
SOFR has been the primary replacement in the U.S. for LIBOR (London Interbank Offered Rate). A major scandal broke when LIBOR was found at the center of a manipulation scheme. The rate was set by a poll of just a handful the biggest banks that tended to take their cues from each other because no one wanted to seem out of step with other major financial institutions.
The flaw was exploited by just a few people who were able to control one of the major interest rates in the world for their own advantage. Given this, the search was on for a replacement and SOFR was selected for a few big reasons:
- It’s based on actual transactions that have already happened rather than banks trying to guess what it would cost them to borrow money from each other.
- SOFR is compliant with international standards regarding controls in place as well as the quality of the benchmark to be representative of the market it’s based on.
- SOFR takes into account not only U.S. Treasury repurchases, but also all trades included in the Broad General Collateral Rate. This means there’s enough volume that it’s much more resistant to manipulation.
Additional SOFR Alternatives
While SOFR is widely used, it’s not the only potential replacement for LIBOR. Here are several of the big ones from the U.S. and around the world:
- SONIA: The Sterling Overnight Index Average is based on what it would cost a bank or other financial institution to borrow sterling overnight from other financial institutions or investors based on actual transaction data. It’s the Bank of England’s equivalent of SOFR.
- Federal Funds Overnight Rate: The federal funds rate is the one interest rate that’s set by the Federal Reserve. It’s actually a target range within which U.S. banks can negotiate to borrow money from each other overnight.
- S. prime rate: A bank’s prime rate is the rate they would give their best customers, usually highly capitalized corporate clients. However, in terms of index rates, the Wall Street Journal prime rate is the one that’s used. It’s based on the base rate that 10 of the largest U.S. banks would charge for a corporate loan.
- CMT: The constant maturity treasury rate is derived from the yield for U.S. Treasuries at a given point in time from a month up to a 30-year Treasury. These are the prices that traders would pay for treasuries with these maturity dates.
What Does SOFR Mean For Home Buyers?
SOFR can impact your mortgage rate, but only for some types of home loans. Fixed rates aren’t impacted because these rates are based on a snapshot in time in the bond market, reflecting what an investor would pay for a mortgage-backed security tied to a given term and financial picture for yourself and similar clients. SOFR impacts adjustable-rate mortgages.
SOFR often serves as the index for an ARM when an adjustment is due. For example, if you have a 5-year ARM, the initial rate is fixed for 5 years. When that period is up, the rate adjusts usually every 6 months or a year, subject to caps and floors that place constraints on how much your rate can rise or fall at each adjustment and over the life of the loan.
In order to get the new rate at the time of each adjustment, your lender adds the index rate, in this case SOFR, to a margin number defined in your contract. For example, if your margin was 2% and the SOFR rate was 5.5% on the day of your adjustment, your new rate would be 7.5%. Many financial institutions use a 30- or 60-day average to control for any wild market swings.
It’s important to note that even for ARMs, SOFR may not be used depending on the lender and loan type. For example, some choose to use CMT or one of the other alternatives discussed earlier for some of their offerings.
The Bottom Line: SOFR Can Affect Your Mortgage Rate
SOFR is the Secured Overnight Financing Rate. It’s one of the primary recommended replacements for the now-defunct LIBOR index used in the United States. Because it’s based on financial transactions that have already happened in the U.S. Treasury repurchase market, it would be much harder for market participants to rig in the way that LIBOR was at the end.
In terms of mortgages, SOFR and some of its alternatives are used by lenders to set rates for ARMs. It serves as the index for the rate adjustment in many cases, although lenders will select their own adjustment methods. Be sure to read your contract. If you think you’re ready to move forward, feel free to apply for a mortgage and lock in an interest rate.