SOFR: What Is It And How Can It Affect Your Mortgage?

Mortgage interest rates tend to move in tandem with a number of benchmarks including the 10-year Treasury, but it ultimately comes down to the yield an investor is willing to accept on the mortgage bond. If you have a fixed rate, your rate doesn’t move.

But what about adjustable-rate mortgages (ARMs)? These have to be tied to a benchmark for adjustments. While there are a number of them, SOFR (the secured overnight financing rate) is one that’s been in the headlines over the last couple of years. We’ll go over what it is, why it’s important and whether it affects your mortgage.

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.

How Does The Secured Overnight Finance Rate 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.

Whichever version of SOFR is chosen, the rate is added to a margin set by your lender to come up with your new interest rate for the rest of the term. You’ll see two different interest rates when your rate changes: the base interest rate and the annual percentage rate (APR).

Your APR is your base interest rate plus closing costs associated with the loan. Because you won’t be paying closing costs again when your rate adjusts, you’ll only need to worry about the new base interest rate.

There are some limitations to how much your rate can change, so to give you a deeper understanding of how this works, we should probably briefly go over how ARMs work.

A Primer On Adjustable Rates

For the purposes of this section, let’s say you’re getting a loan that’s being advertised as a 7/6 ARM with 5/1/5 caps and a 3% margin. Let’s run through what each of these individual numbers mean.

The 7 is the number of years the interest rate stays fixed at the beginning of the loan. The main attraction of ARMs is that almost always, you’re paying a lower rate than what you could get for a fixed-rate loan with a comparable term. It should be noted that ARM terms are typically 30 years, although they don’t have to be.

The 6 represents the adjustment interval for the loan after the initial fixed period has expired. In this case, the rate adjusts every 6 months. With each adjustment, your payment is recalculated such that even after the change in interest rate, your loan still pays off in the same amount of time if you make your payments based on the schedule.

The second half of this is the cap associated with the loan. These are limits on how much the rate can go up or down in any given adjustment.

The first 5 is the initial cap. The rate won’t go up or down more than 5% on the first adjustment. The 1 means that with each subsequent adjustment, the rate won’t change more than 1% in either direction. The last 5 is the lifetime cap, meaning that the rate won’t go up or down more than 5% over the life of the loan. Finally, the rate will never fall below the margin set by the lender.

Although the concept of adjustable rates can be scary for some, it’s important to note that when you qualify for an ARM, your lender is assuming you’ll be making the highest possible payment you could be under the contract. Therefore, if your lender qualifies you, you’ll know you can afford the payment.

No one ever wants to pay more than they have to, so you still may choose to refinance into a fixed rate down the line depending on market conditions, but payment shock should be less concerning.

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. It also may or may not have an effect depending on how your mortgage rate is determined. Let’s run through how this could impact mortgages going forward or even your current one.

How Will SOFR Affect Current Mortgages?

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 adjustable-rate mortgage 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.

If you have an existing ARM mortgage based on LIBOR, keep an eye out for communications from your lender and/or servicer regarding what the new benchmark interest rate for your loan adjustments will be.

How Will SOFR Affect Future Mortgages?

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. As just one example, Rocket Mortgage^® uses the 30-day average of SOFR to determine adjustments for newly originated conventional loans.

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.

SOFR is replacing LIBOR, but to truly understand why, it helps to go over how we got to this point. This will also help you get a feel for the difference between the indexes.

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 a high 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., the presumptive replacement is the Secured Overnight Financing Rate.

The major difference between the two is that LIBOR is forward-looking. It requires banks to say what they think they would charge for borrowing overnight. Because SOFR is based on repurchases of U.S. Treasuries, it’s based on transactions that have already happened.

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.

SOFR is the secure overnight financing rate. The rate is based on U.S. Treasury repurchases between banks. It’s used as a benchmark for adjustable-rate mortgages, among other things. Because it’s a backward -looking index, it’s not vulnerable to manipulation like LIBOR. LIBOR is being phased out, but it relied on banks forecasting overnight borrowing rates.

If your mortgage was previously tied to LIBOR, your lender will be in communication with you about any changes to the benchmark interest rate that the adjustments for your loan are based on. For even more mortgage resources, check out our Rocket Mortgage Learning Center.