What it means
The rate is published by the Federal Reserve Bank of New York and is a volume-weighted median of overnight repurchase agreements, deals in which cash is lent against government bond collateral and reversed the next day. Because that market turns over enormous volumes daily, the rate is very hard to manipulate, which was the central failing of the benchmark it replaced.
The switch matters to any business with floating rate debt. Loan agreements that once read "LIBOR plus a margin" now read "SOFR plus a margin", and because SOFR is secured while LIBOR carried bank credit risk, contracts usually add a small fixed spread adjustment so the economics stay broadly unchanged.
There is a practical wrinkle to be aware of. SOFR is an overnight rate, but most loans pay interest monthly or quarterly, so lenders either compound daily SOFR in arrears across the period or use Term SOFR, a forward-looking rate published for one, three, six and twelve month periods that behaves more like the old benchmark.
Treasurers should check how their agreement handles the lookback period and any rate floor. Compounding in arrears means the final interest amount is not known until close to the payment date, which complicates cash forecasting, and many agreements set a floor so the reference rate cannot go below zero.
SOFR also behaves differently in a crisis, which is worth understanding before it happens. Bank funding costs rise when credit markets are stressed, while a rate secured on government bonds can fall, so a borrower's interest can drop at the very moment their lender's own costs are climbing.
In practice
Real-world examples.
Example
A property developer refinances a $30,000,000 construction facility as its old LIBOR-linked loan matures. The new agreement uses Term SOFR plus a margin plus a fixed spread adjustment, so the total cost lands within a few basis points of the old deal.
Example
A treasury team is asked why the interest accrual on a compounded facility keeps changing during the month. The answer is that the rate is calculated from daily fixings in arrears, so the final figure is only known a few days before payment.
Example
A manufacturer with $20,000,000 of SOFR-linked debt buys an interest rate swap that fixes its reference rate for three years. Its interest cost becomes predictable, which allows the board to approve a capital plan with confidence in the financing line.
Think of it
“SOFR is the US benchmark rate based on overnight Treasury repo-the LIBOR replacement.
Formula
Calculation
Interest for a period = Principal x (Reference rate + margin) x days / 360.
A company draws $5,000,000 on a revolving facility priced at three-month Term SOFR plus a margin of 2.25%. With Term SOFR at 4.30%, the all-in rate is 4.30% + 2.25% = 6.55%. For a 90-day interest period the calculation is 5,000,000 x 0.0655 x 90 / 360 = $81,875. On a full-year basis that is 5,000,000 x 0.0655 = $327,500, and if the reference rate fell to 3.30% the all-in rate would become 5.55% and the annual cost would drop to 5,000,000 x 0.0555 = $277,500, a saving of $50,000.Case study
Seen in the real world.
Larkspur Foods is an invented company used purely for illustration. It carried $15,000,000 of floating rate debt and, during the transition away from LIBOR, accepted its bank's first proposal without modelling the outcome.
The finance team later worked through the numbers and found the proposed margin had been widened by 0.35% on top of the standard spread adjustment, which on $15,000,000 amounted to $52,500 a year. Raising this with the bank produced a revised quote closer to the market convention.
The illustrative point is not that the bank behaved badly, but that benchmark transitions repriced thousands of agreements at once. Borrowers who compared the old and new all-in rates on a like-for-like basis negotiated better terms than those who assumed the change was purely mechanical.
Watch out
Common mistakes.
- Comparing a SOFR rate directly with an old LIBOR rate without allowing for the credit spread adjustment, which makes the new rate look artificially cheap.
- Assuming SOFR behaves like a bank borrowing rate, when it is secured on government bonds and can move in the opposite direction during a credit squeeze.
- Overlooking the compounding convention in a loan agreement, then finding that interest cannot be forecast accurately until days before payment.
Questions
People also ask.
Why was LIBOR replaced?
It relied on banks estimating what they would pay to borrow rather than on actual transactions, which left it open to manipulation and made it unreliable as underlying volumes shrank.
What is the difference between Term SOFR and compounded SOFR?
Term SOFR is known at the start of the period and is easier to forecast, while compounded SOFR is built from daily rates over the period and is only final near the end of it.
Does SOFR apply outside the United States?
It applies to US dollar borrowing wherever the borrower is based, and other currencies have their own replacement benchmarks with similar designs.
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