Secured Overnight Financing Rate defined and explained

If you have an adjustable-rate mortgage or plan to get one to buy a home with, you should be familiar with SOFR, which stands for Secured Overnight Financing Rate. SOFR is important because it helps determine mortgage interest rates and whether the interest rate and monthly payment on your ARM increase or decrease, and by how much when it adjusts.

Key takeaways:

• SOFR is based on the interest rates banks charge each other to borrow money overnight.
• Mortgage lenders use SOFR as a benchmark for setting mortgage rates for borrowers.
• When rates are adjusted on adjustable-rate mortgages, lenders follow SOFR. If SOFR rates increase, your ARM rate is likely to increase as well.

What is SOFR?

SOFR is the interest rate set by the U.S. Treasury that determines how much it costs for banks to borrow money overnight from each other to ensure they have enough cash to meet their reserve requirements.

The SOFR is a reference rate that reflects the cost to banks and lenders of borrowing money. Therefore, SOFR offers a broad measure of interest rates. Mortgage lenders use SOFR as a benchmark, adding their margin to determine the interest rates they set for mortgages. If SOFR increases, you can expect mortgage rates to follow. If SOFR rates fall, so will mortgage rates.

SOFR is the dominant U.S. dollar interest-rate benchmark, according to the Federal Reserve Bank of New York.

How does SOFR work?

SOFR is based on the overnight cost of borrowing through the repurchase of U.S. Treasuries. The Federal Reserve Bank of New York publishes the daily SOFR on its website at or close to 8 a.m. ET each business day.

If you have a fixed-rate mortgage, SOFR will affect the rate you receive when you first take out your mortgage and will remain at that rate for the duration of the loan. If you have an ARM that’s tied to the SOFR rate, whatever the SOFR rate is on the date your mortgage rate is scheduled to adjust affects whether your rate increases or decreases and by how much.

Here's how Rocket Mortgage® handles ARMs tied to SOFR: We use a 30-day rolling average of SOFR published by the Bank of New York to reset ARM interest rates. Rocket Mortgage resets the 30-day rolling average to the nearest 0.125%.

Say SOFR's 30-day rolling rate is 4.975% on the day on which your ARM's interest rate is scheduled to adjust. Rocket Mortgage will round up your SOFR average to 5%. If you had a 2% margin in your loan contract, your new interest rate would be 7%. Your new rate, however, will never exceed the cap listed in your loan agreement.

History of the secured overnight financing rate

SOFR wasn't always this important for borrowers with ARMs. There was a time when the interest rates of most ARMs were instead tied to another benchmark rate – the London Interbank Offered Rate, better known as LIBOR.

Why did the Federal Reserve make the switch from LIBOR to SOFR?

According to the Federal Reserve Board, LIBOR wasn’t based on actual market activity, and traders determined a way to fix the price of LIBOR. This indirectly harmed consumers whose loans or credit cards had interest rates tied to the fluctuations of an easily manipulated LIBOR.

SOFR’s replacement of LIBOR

In 2017, the Alternative Reference Rates Committee of the Federal Reserve and Federal Reserve Bank of New York unanimously selected SOFR as its recommended alternative to LIBOR.

In 2021, U.S. banking regulators stated that financial entities should stop the use of LIBOR as of Dec. 31, 2021.

On June 30, 2023, all banks and financial institutions formally stopped using LIBOR.

SOFR is now the primary U.S. dollar interest-rate benchmark.

SOFR vs. LIBOR

As the financial world shifts from LIBOR to SOFR, understanding the differences can help you feel more confident in your financial choices.

Overall, SOFR provides a more precise and more consistent view of interest rate trends. While the shift from LIBOR to SOFR may seem technical, it ultimately gives you a more reliable foundation for financial decisions – especially when it comes to borrowing with confidence.

What is SOFR today?

The Alternative Reference Rates Committee states that SOFR is a more reliable benchmark than LIBOR, mainly because more than $1 trillion in daily transaction volumes underpin this rate. As the committee says, the volumes underlying SOFR are far larger than the number of transactions in any other U.S. money market.

This sheer volume of transaction activity protects SOFR from manipulation by traders. As a result, the rates committee is likely to continue recommending that financial institutions use SOFR when setting interest rates on mortgages.

FAQ

Here are answers to common questions about SOFR.

Why does SOFR matter if I’m buying a home today?

If you’re considering an ARM, SOFR will affect how your rate adjusts. Even if you choose a fixed-rate loan now, understanding SOFR can help with future decisions around refinancing or tapping into home equity.

Can SOFR affect how much I qualify to borrow?

Potentially. A higher SOFR can result in higher starting rates for ARMs, which may affect your monthly payment and the amount you can afford to borrow for a home purchase.

How often does SOFR change?

SOFR is published daily by the Federal Reserve Bank of New York. Rocket Mortgage uses a 30-day rolling average of SOFR to help smooth out daily fluctuations when adjusting ARM rates.

What happens if SOFR goes up significantly?

If SOFR rises, your ARM’s interest rate might increase at your next adjustment. Most ARMs include rate caps to protect you from significant jumps.

Is SOFR only used for mortgages?

Not at all. While it plays a significant role in ARMs, SOFR also sets the pace for everything from business loans to student loans. It’s the standard for lending in the United States.

The bottom line: Understand the basics of SOFR

While homeowners don’t need to understand the intricacies of SOFR, knowing the basics of how this financing rate works can help you prepare for the interest rate changes that usually come when adjustable-rate mortgages enter their adjustment period.

If you’re debating between a fixed-rate or adjustable-rate mortgage, you can apply for a mortgage with Rocket Mortgage today. Our Home Loan Experts can help you find the mortgage loan that’s best for you.