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What Is SOFR And How Can It Affect Your Mortgage?

Kevin Graham7-minute read

June 17, 2021


Your personal mortgage rates are based on a number of factors. There’s also no shortage of confusing terminology. Some lenders may quote you rates by talking about it being “the base plus 2 points.” What?

For the average consumer who doesn’t deal with mortgages every day, jargon only serves to render concepts incomprehensible. It’s our job to decode the lingo so that when you’re ready to apply for a mortgage, you can do so with confidence.

We’ve gone over mortgage points previously. Today, we’ll go over one of the ways base rates are set: the Secure Overnight Financing Rate (SOFR).

What Is The Secured Overnight Finance Rate (SOFR)?

SOFR is an interest rate set based on the cost of overnight borrowing for banks as defined by U.S. Treasury repurchase agreements – also called repos. It’s the front runner being recommended by the Alternative Reference Rates Committee (ARRC) to serve as the replacement for the London Interbank Offered Rate (LIBOR), which is being phased out at the end of 2021 as a result of a manipulation scandal.

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Why Is LIBOR Being Replaced?

No discussion of SOFR can really be undertaken without discussing why it has come into existence. After all, LIBOR was considered the most important measure of borrowing costs between banks for years.

In 2012, it came out that traders had figured out a way to fix the price of LIBOR, thus skewing the metrics for bank borrowing costs and, by a trickle-down effect, indirectly manipulating borrowing costs paid by consumers whose loans or credit were tied to the movements of the index.

The details of the scandal make for fascinating reading, but for the purposes of understanding the difference between LIBOR and its successor, we’ll attempt a brief synopsis.

LIBOR is set based on bank representatives giving estimates of what they think the cost of borrowing money from other banks will be. This estimate is made available for a number of the world’s major currencies.

In times of heavy trading of securities between banks, this estimate closely mirrors market movements because the employees setting the rates know what they are actually paying.

Some major banks started to collapse during the financial crisis just over a decade ago. When this happened, the market for lending between banks dried up, so that if banks wanted to borrow money from other banks, they would pay much higher rates of interest. Banks were being much more careful to guard their reserves.

However, LIBOR didn’t rise at a rate that would be expected given these market dynamics. There were two major reasons for this:

  • Because there wasn’t the volume of interbank trading, there was a much greater degree of guesswork involved in the estimates.

  • No one wanted to be on the high end of estimates for fear of causing a panic about the financial stability of banks. The idea was to make it seem as though money could be easily moved.

This environment opened the way for manipulation because in the absence of actual trades on which to base their estimates, those in charge of setting the rates at the individual banks started to rely on brokers to give them an idea of general market sentiment.

Because of this, some brokers and traders conspired and undertook a scheme to fix the price and make trades based on this inside knowledge. This resulted in a number of indictments.

When the group that regulates LIBOR announced in 2017 that the rate shouldn’t be relied upon after 2021, this set off a mad scramble to find a replacement. In the U.S., that was the Secured Overnight Financing Rate.

How Does SOFR Work?

Now that you know the shortcomings of LIBOR, how does its replacement work? As noted above, SOFR is based on U.S. Treasury repurchase agreements. A repurchase agreement is a short-term lending contract based on collateral. Here’s an example:

Let’s say a bank has $10 million worth of U.S. Treasury bonds. They work out an agreement with an investor to take those bonds off their hands in exchange for $10 million only to buy those bonds back at some later date for the original price, plus an agreed-upon rate of interest.

There are two types of repurchase agreements: term and open.

Term agreements are sold back to the investor at the end of an agreed-upon time frame as short as a day or two. Interest is based on an agreement between the parties at the time of the contract.

Open agreements have no specific end date, but either party can terminate the agreement whenever they want and trigger the repurchase. In this case, the amount of interest paid may be recalculated by mutual agreement periodically.

SOFR is based upon the average interest rates banks are getting when they participate in these repurchase agreements. Unlike LIBOR, the rate is based on transactions that have already happened as opposed to estimates of future transactions.

Although this rate is reported daily by the Federal Reserve Bank of New York, most lenders or creditors that want to set rates based in whole or in part on SOFR are likely to use a rolling average in order to smooth daily volatility.

Is SOFR Better Than LIBOR?

New doesn’t always mean better, so the question that may come to mind is how SOFR is better than LIBOR. Let’s take a minute to run through this.

SOFR’s primary advantage over LIBOR is the fact that it can’t be manipulated as easily. Instead of being based on a prediction, it’s based on historical data.

There are also some cons. Among them is the short track record of SOFR, which has only been around since April 2018. Because of this, it’s not as useful for economic analysts to determine what’s going to happen in the economy based on the historical movements of SOFR like they could with the much more established LIBOR.

However, given that LIBOR was able to be influenced by traders and brokers to their own ends, maybe LIBOR wasn’t the predictive model those who relied on it might have thought previously.

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How Does SOFR Impact The Cost Of My Mortgage?

SOFR may or may not have an impact on the cost of your mortgage. It’s also going to come down to the type of mortgage you have. Let’s run through how this could impact mortgages going forward or even your current one.

How Will SOFR Affect My Future Mortgage?

In the future, lenders may choose to use SOFR as a base rate for the cost of getting a mortgage in the way that lenders currently use rates like LIBOR, the Constant Maturity Treasury (CMT) or the prime rate from the Wall Street Journal.

SOFR could be used as an index rate for ARM adjustments as well as base rates for fixed mortgages that lenders choose to keep in their portfolio.

It’s worth noting the fact that most mortgages are now sold on the secondary market to investors in mortgage-backed securities (MBS). A fixed-rate mortgage sold on this market will have its base rate determined by the yields on these securities.

After your base rate is determined, other factors play into your individual rate which are based on your personal financial situation. These include your credit score, debt-to-income ratio and how and if you plan to occupy the property. All of these things help a lender determine the relative risk of default on the loan and the appropriate interest rate to charge you.

How Will SOFR Affect My Current Mortgage?

If you’re looking at this transition to SOFR and wondering how it will impact your current mortgage, that’s largely going to depend on whether you have a fixed-rate mortgage or an ARM.

If you have a fixed-rate mortgage, nothing is going to change because your rate is locked in place for as long as you have that loan.

If you have an ARM with a term extending past 2021 that also has adjustments currently pegged to the movements of LIBOR, your lender will have to find a new index with which to tie adjustments. One option is SOFR. As with any adjustment, your rate has the potential to go down, but it could also go up. It’s all about market conditions at the time.

Are There Alternatives To SOFR?

While SOFR is the talk of the town because it’s the index widely presumed to succeed LIBOR in the U.S., there are alternatives that lenders can choose to use instead.

For starters, LIBOR and SOFR will coexist in the U.S. through the end of 2021. Additionally, lenders in the U.S. looking for something to base their mortgage rates on would also have the option of using something like the CMT or the prime rate.

It’s noteworthy that SOFR is being used for transactions tied to the U.S. dollar. Other countries are developing their own alternatives. For example, the UK has the Sterling Overnight Interbank Average Rate (SONIA) and the European Union is using the Euro Overnight Index Average (EONIA).

Summary: SOFR Could Affect The Price Of Your Mortgage

The Secured Overnight Funds Rate is considered the top contender to replace LIBOR upon its retirement at the end of 2021. The replacement is happening as a result of the index fixing scandal.

Unlike LIBOR, SOFR is tied to actual transactions, specifically U.S. Treasury repurchase agreements. Because of that, it’s not as vulnerable to rigging. If there’s a downside, the fact that it’s newer means that analysts won’t be able to predict economic trends as accurately as they can with something like LIBOR which has a longer history behind it.

If you have a fixed-rate mortgage that you’re considering or currently have, it’s unlikely that SOFR will have any impact because rates are set for fixed mortgages based on sales into the MBS market. If you have an ARM, SOFR is one viable alternative to replace LIBOR. However, there are alternatives whether you’re looking domestically or internationally.

Now that you know more, maybe you’re ready to put it into practice. You can apply online. Feel free to check out the mortgage resources on our Learning Center!

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Kevin Graham

Kevin Graham is a Senior Blog Writer for Rocket Companies. He specializes in economics, mortgage qualification and personal finance topics. As someone with cerebral palsy spastic quadriplegia that requires the use of a wheelchair, he also takes on articles around modifying your home for physical challenges and smart home tech. Kevin has a BA in Journalism from Oakland University. Prior to joining Rocket Mortgage, he freelanced for various newspapers in the Metro Detroit area.