SOFR: Secured Overnight Financing Rate, Explained

When you’re looking at home financing, one of the biggest decisions to make is the type of interest rate you want to go with. If you end up with an adjustable-rate mortgage (ARM), one of the central indexes for adjustment is the Secured Overnight Financing Rate (SOFR). We’ll go over what the index is, how it works and the potential impact on your mortgage.

The Secured Overnight Financing Rate (SOFR) is an interest rate set by the U.S. Treasury that determines the cost of overnight borrowing for banks through Treasury repurchase agreements – also called repos.

Due to its recommendation by the Alternative Reference Rates Committee of the New York Fed, SOFR is the most widely used replacement for loan rates that were originally tied to the London Interbank Offered Rate (LIBOR). The last vestiges of LIBOR went away in June 2023.

SOFR is based on the overnight cost of borrowing through repurchases of U.S. Treasuries. This was used because the size of the repo market in terms of volume of trades makes it hard to manipulate for the gains of any one entity.

Each business day, the Federal Reserve Bank of New York publishes a median of treasury repurchase yields weighted based on the volume of trades for the previous business day. This becomes the new SOFR rate.

SOFR and rates like it can be used to set a new base interest rate when the adjustment interval hits for ARMs. Don’t confuse the base interest rate and the annual percentage rate (APR). The base interest rate affects your monthly interest payment, whereas APR combines that and closing costs along with mortgage insurance to contemplate total loan costs.

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 the type of mortgage you have.

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 that also had adjustments previously pegged to the movements of LIBOR, you should have received communication from your lender regarding the transition to a new index. One option was 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.

Regarding how adjustments are handled, the Federal Reserve didn’t want anyone using the rate from a single day because of the potential for volatility. Rocket Mortgage^® uses a 30-day rolling average of SOFR as published by the Bank of New York to reset mortgage rates for ARMs. This is rounded to the nearest 0.125% and added to the margin in your loan documentation.

As an example, let’s say your ARM is tied to SOFR and the 30-day rolling rate is 4.975% on the day of your adjustment. The SOFR average would round up to 5%. If you had a 2% margin in your contract, the new rate would be 7%. The exception to this is that your rate will never be higher than the specified cap in your loan agreement.

We’ve talked a lot about how adjustments are handled, but it’s also important to know that this has nothing to do with how your mortgage rate is determined when you first apply for your loan. This is based not only on current movements in the bond market but also personal and financial factors like your credit score, the size of your down payment and property occupancy.

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.

There are several alternatives to SOFR, both in the U.S. and across the world. Let’s briefly run through them.

• Sterling Overnight Index Average (SONIA): This is based on the cost for banks in England to borrow sterling overnight. It functions like SOFR but adapted for another currency.
• Federal Funds Overnight Rate: Also referred to as the federal funds rate, this is a reference rate range for banks insured by the Federal Reserve to borrow from each other. The Federal Open Market Committee makes interest rate decisions eight times per year.
• Ameribor: Started by the American Financial Exchange, this is based on borrowing costs of a representative sample of small, medium-sized and regional banks in America looking for a different standard.
• S. prime rate: As a general financial term, the prime rate is the interest rate a bank would charge its most credit worthy clients. As an index, the Wall Street Journal definition of the rate charged by at least 70% of the 10 largest banks in the nation for corporate loans is generally what’s relied upon.
• Constant maturity treasury (CMT): CMT trading is another treasury-based rate-setting alternative. The CMT is used for FHA and VA ARM loans while Rocket Mortgage uses SOFR for conventional and Jumbo Smart loans.

SOFR is an overnight borrowing rate based on recent repurchases of U.S. Treasuries. It replaced LIBOR, which was gamed by savvy traders based on the inherent weakness of relying on predictions of what the borrowing rate was going to be. When it comes to mortgages, SOFR and indexes like it are used to calculate adjustments on ARMs.

Now that you know a lot more about all things mortgage rates, if you’re ready to buy or refinance your home, you can go ahead and apply for a mortgage with Rocket Mortgage today.