What it means
Plain SOFR is an overnight rate, published each morning for the day before, which makes it awkward for a loan: a borrower would only learn the period's interest at the very end, after averaging every day's rate. Term SOFR solves that by taking prices from SOFR futures and swaps and turning them into a single rate for the whole coming period, fixed and published in advance.
That advance certainty is why treasurers care. A finance team can set a rate on the first day of a quarter, model the interest cost, forecast cash and hedge it, rather than waiting until the last day to discover the bill.
It behaves like the old LIBOR convention that loan systems, covenants and cash forecasts were all built around. In a loan agreement Term SOFR is never used alone.
The borrower pays Term SOFR plus a credit spread set by the lender for the borrower's risk, often with a further small credit spread adjustment on legacy deals converted from LIBOR, and interest is normally calculated on an actual over 360 day-count basis. Many agreements also add a floor, so that if Term SOFR falls below zero or below a stated level the lender still earns a minimum.
There is one important restriction on how it can be used. Term SOFR is produced by an administrator under licence and its use in derivatives is deliberately limited, so while it dominates bank loans, the wider derivatives market still trades on compounded overnight SOFR.
That mismatch is why hedging a Term SOFR loan sometimes leaves a small basis risk. The practical nuance is that Term SOFR is close to a risk-free rate, unlike LIBOR, which carried bank credit risk inside it.
When credit conditions deteriorate, LIBOR would rise on its own, partly cushioning lenders; Term SOFR will not, which is why credit spreads on SOFR loans are usually a little wider than the equivalent LIBOR margin was.
In practice
Real-world examples.
Example
A private equity-backed distributor refinances a $60,000,000 term loan from LIBOR to three-month Term SOFR plus 3.25%. Because the rate is fixed on day one of each quarter, the finance team can lock the quarter's interest into the cash forecast rather than estimating it.
Example
A commercial property owner takes a floating rate mortgage priced at one-month Term SOFR plus 2.50% with a 0.50% floor. When short rates fall sharply, the floor means the borrower keeps paying at least 3.00%, which the owner had not modelled in the downside case.
Example
A treasurer hedging a Term SOFR loan buys an interest rate cap based on compounded overnight SOFR because term-based derivatives are restricted. The hedge works well but leaves a small residual difference between the loan rate and the hedge rate, which the team monitors quarterly.
Think of it
“Term SOFR is forward-looking SOFR rates-set at the start of the interest period.
Formula
Calculation
Interest for the period = Principal x (Term SOFR + margin) x (days in period / 360)
A manufacturer draws $5,000,000 on a revolving credit facility for a three-month period of 90 days. On the first day, three-month Term SOFR is set at 4.20% and the facility margin is 2.00%, giving an all-in rate of 4.20% + 2.00% = 6.20%.
Annualised, that is $5,000,000 x 6.20% = $310,000. For the 90-day period the interest is $310,000 x (90 / 360) = $310,000 x 0.25 = $77,500.
Now suppose that at the next quarterly reset three-month Term SOFR has climbed to 4.70%. The all-in rate becomes 6.70%, and interest on the same drawn amount for another 90-day period is $5,000,000 x 6.70% x 0.25 = $83,750. The reset has added $6,250 to a single quarter's interest cost, which is the number a cash forecast needs to capture.Case study
Seen in the real world.
Halberd Logistics is an illustrative fictional freight business carrying a $24,000,000 floating rate facility that was converted from LIBOR to three-month Term SOFR plus 2.75%. The finance director assumed the switch was cosmetic and left the annual budget unchanged.
Two things then diverged from the plan. Term SOFR reset upward twice in the year, and the loan documentation used an actual over 360 day-count while the budget model had used a simple quarterly division, understating interest slightly at every reset. The combined effect added a little over $400,000 to the year's interest against budget, most of it from the rate resets rather than the day-count.
In this fictional example the fix was mechanical rather than clever: the model was rebuilt to read the published rate at each reset date, apply the correct day-count, and flag any quarter where the all-in rate moved more than 0.25 percentage points. Interest stopped being a surprise line in the variance report.
Watch out
Common mistakes.
- Treating Term SOFR and overnight SOFR as interchangeable, when one is fixed in advance for a period and the other is an overnight rate averaged after the fact.
- Budgeting interest on the current rate for the whole year, ignoring that the rate resets every one, three or six months depending on the chosen period.
- Forgetting the actual over 360 day-count convention, which makes a full year of interest slightly higher than a simple annual percentage suggests.
Questions
People also ask.
Is Term SOFR the direct replacement for LIBOR?
For most US dollar bank loans yes, but the derivatives market largely moved to compounded overnight SOFR instead, so the two products can reference slightly different rates.
Why does my SOFR margin look wider than my old LIBOR margin?
Because SOFR is close to risk free while LIBOR included bank credit risk, so lenders rebuilt that missing element into the spread.
What is a SOFR floor and why is it there?
It is a minimum level for the benchmark written into the loan, protecting the lender's return if rates collapse, and it means falling rates may not reduce your interest as far as you expect.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%